Investing In Mutual Funds? Diversify But Avoid Duplication

Building an efficient mutual fund portfolio is a difficult task. But the general perception does not recognise this fact. Most retail investors follow a simplistic process. They sort mutual fund schemes based on their past performance and pick better-performing schemes for investment.

Hindsight investing is fraught with its own risk and it further gets complicated by adding too many schemes in the name of diversification. A study of 30 open-ended schemes’ portfolio shows that they invest in 1,790 stocks in total, out of which there are only 552 unique stocks. It means there are 1,238 stocks that appear in the portfolio of two or more schemes. This is in effect means you are owning the market and any meaningful out performance over the index is a pipe dream.

When one invests on the basis of past performance without understanding the underlying approach or style, there is a high possibility that the investor may end up buying schemes that are managed in a particular style - growth or value investing. Investors may lose on two fronts. First, the investor ends up increasing risk rather than reducing it. Duplication or investing in too many stocks across schemes will invariably lead to average returns. One can’t generate extra returns by excessive.

Second, when a particular style is being rewarded there is a risk of the portfolio being concentrated in that style of investing due to performance bias. If the style works, portfolio performs. If not, portfolio’s returns languish. For example, consider a cricket team. One is likely to prefer a cricket team that has batsmen with varying styles along with fast bowlers, off spinners, leg spinners and all rounders. Such team is likely to perform well more consistently over the long term even as pitches and weather vary. Hence, it is imperative that consistent performance should be the paramount reason for diversification across investment styles while choosing mutual fund schemes.

To understand a fund manager’s style of investing one needs to carefully study four ‘C’s — clarity of philosophy and style, capabilities of manager and the asset management company (AMC), consistency of performance and approach and class of the manager.

Once you understand the investment management style, you can identify the right fund managers to grow your money. Please note, it is the fund manager’s selection that counts and not the scheme selection. Carefully selected fund managers across investment styles focus on earnings growth, value or a mix of value and growth and can deliver much better returns if they stick to their stated style of investing.

Mutual fund schemes selected after considering the varying investment styles can offer more meaningful diversification. An individual investor can build a mutual fund portfolio by incorporating five or six managers. A carefully designed model portfolio of eight schemes that invest money in varying ways invest in 477 stocks of which 254 are unique stocks. Such a portfolio brings in the much-needed smart diversification and also helps investors to participate in upside move while minimising risk.

If one is looking for long-term wealth creation using mutual funds, then do not get carried away by short-term performance numbers. Adding or redeeming from fund managers based on near-term performance will lead to disappointments as there is a lot of mean reversion which happens. This leads to chasing returns and sub-par portfolio returns. Based on a study done in the US on one of the legendary funds which generated 20% p.a. for close to 20 years, it was noticed that the average investor return was only 9%. This was due to investors moving in and out at the wrong time based on markets or near-term performance of the fund.

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