The Signal : Diversification Vs. Di-worsification: What’s your portfolio up to?

Arun, a mutual fund investor, understands the significance of diversification from the online session he attends on investing. Currently, his portfolio consists of 6 equity diversified mutual funds; after a few months of attending the session, Arun’s portfolio expanded to 14 diversified equity funds. Arun believes that having more funds in the portfolio offers ample diversification like any other investor.

Over the next few months, the stock markets dip significantly; Arun notices that all 14 funds record a fall in value in line with the fall in the market. But the question here is that this was the advice given to Arun in his online session to diversify his portfolio. When learning more about his funds, Arun discovers that the underlying holdings of all of his 14 mutual funds are very similar, and hence no wonder why he sees such a performance from all his mutual funds.

Rajiv, another investor, invests in both direct equity shares and equity mutual funds. Like Arun, upon further study of his portfolio, Rajiv learns that his mutual funds also hold direct stocks.

Here the term portfolio overlap comes into the picture – portfolio overlap means investing in the same securities through different investment schemes/avenues. At the same time, Arun finds himself dealing with this problem due to investments in multiple mutual funds schemes with the same investment objective. Rajiv finds himself facing this problem due to holding equity securities present in the portfolio of equity mutual funds in which he has invested.

When a fund house launches a new fund (NFO), the fund manager invests the money collected from investors into financial instruments per the scheme’s investment objective and per SEBI mandate in a particular category. For example, in the case of large-cap funds, SEBI defines the universe as the first 100 companies as per their market cap to be considered large-cap companies. Since the universe is limited, it is common for all the funds launched in the same category. And since the investment objective of all large-cap funds is the same, it will feature a significant amount of similar stocks in the portfolios of all these funds. For instance, if Axis Bluechip Fund has invested in shares of Infosys Ltd, Mirae Asset Large-cap fund has also have invested in shares of Infosys Ltd; in fact, both funds may have supported an almost similar percentage of their portfolio in shares of Infosys Ltd. In other words, the Axis Bluechip Fund and Mirae Asset Large-cap Fund overlap in their portfolio. Now, if the price of Infosys’s shares falls, the value of both funds’ portfolios will fall. Arun finds himself in a situation such as this.

To avoid portfolio overlapping following checks can be adopted

Fund manager check: Mr. A is a good fund manager, and his funds have delivered excellent returns. Is it advisable to invest all your money only in his funds? Not really!

Just like you have your style of doing things, fund managers have their style of picking up stocks. If a fund manager is bullish on a stock or sector, they will probably ensure that that particular stock or sector is part of all the funds they manage. So, inadvertently you could be increasing stock-specific/sector-specific risk because the weight of that stock/sector will go up in your portfolio. Imagine investing half of your money in the real estate or pharma sector alone? You could miss the bull run in other sectors such as an automobile.

Fund house check: Every household has a value or adopts a culture that’s unique to it. In line with this, every fund house has a unique investment strategy that all its fund managers follow. So, do not invest in several Mutual Funds from one fund house. Invest across fund houses so that your portfolio is a well-diversified one.

Yes, there will indeed be some amount of portfolio overlap in your portfolio at any given point in time.

While an investor cannot wholly avoid overlaps, they must attempt to reduce this overlap to the extent possible to achieve proper diversification. It will also help diminish stock correlation and decrease the risk of over-diversification /overexposure. Therefore, check the portfolios before you invest or write to us to identify the same in your mutual portfolio.