When investing, we search for the best mutual funds to achieve our goals. This is done based on our own research or advice, it is a tedious task considering hundreds of mutual fund schemes around. If we shortlist 20 mutual funds, we tend to invest in all 20 or maybe the best 10, this scheme elimination is tough and complicated. There are also investors who hold 30-40 mutual funds in their portfolios and some even more. Everyone has his own number, there are also investors who have just 2 or 3, though that is a rarity. Then there’s confusion around how many of a certain category of funds to own.
So, what is the right no of funds one should have in a portfolio?
Should all these be equity funds or debt funds?
If equity-then how many large, mid, or small cap funds?
Let us understand the way to approach all these questions and what we should do.
Ideal Number of Funds in a Portfolio
Before answering this question, you need to work out your ideal asset allocation i.e. how much should be invested in equity or debt and on what basis. You can also read one of our earlier posts on this-https://www.wishfin.com/mutual-fund/what-is-asset-allocation-in-mutual-funds/. Once the asset allocation is decided, you would know how much of your portfolio should be invested in which asset class.
Say your asset allocation comes to 80:20 i.e. 80% of your portfolio should be in equity funds and 20% in debt funds. Let us look at the equity allocation first. Common thinking would say, invest in10 equity funds with 8% each that would make your 80% but is this the ideal no? Typically, any equity mutual fund portfolio has 50-70 stocks, and assuming you own 10 such equity funds, you own about 500-700 stocks in your portfolio. A lot of funds also have an overlap in the stocks they hold, normally this ratio is around 30% i.e. same stocks held by different mutual fund schemes. If we remove these, we will be left with 350-500 stocks. In the Indian stock markets, there are about 300-400 companies that are considered investible by mutual funds. Therefore, through 10 funds, you own the entire investible universe of stocks.
What is Wrong in This?
- Firstly, if you wish to own the entire universe, why not just buy a single index fund say a BSE 200 or a BSE 500 consisting of top 200 or 500 companies which will lead to low cost as well( lower expense ratio) than holding 10 funds.
- Secondly, when you own so many stocks, this portfolio will not be able to generate better returns than the market itself since you own the entire market. Thus, the ideal number should be about 3 equity funds which would have about 100-120 stocks, this portfolio will have a higher probability of delivering returns better than the market. Now coming to debt funds, the same rule applies-no point in buying 5-10 debt funds. Just own about 2 debt funds thereby your ideal portfolio should have about 5 funds with 3 in equity and 2 in debt. Mind you this is for a 80:20 portfolio, if your allocation is opposite that is 20% in equity and 80% in debt then you can hold 2 debt funds and 3 equity funds.
- Thirdly, the higher the number of funds, the more difficult it is to monitor each of them. After investing, one needs to monitor the funds and rebalance portfolio whenever necessary. A higher number of funds make this task difficult. Monitoring 5 funds vs 20 funds is certainly easier.
Equity, Debt or a Mix of Both?
There is no standard answer for this, this will vary basis the asset allocation you arrived at. It could be 50:50 for someone or 80(equity) and 20(debt) for someone else. However, one should ensure that 100% should never be invested in only one asset class-diversification is very important. The right asset allocation keeps you in good stead especially in difficult times. When one asset class is not performing well, the other can maintain balance in the portfolio and avoid erosion of returns. Case in point is the last couple of years when equity funds have delivered negative returns, but many debt funds have delivered double digit positive returns.
How Many Large, Small or Midcap Funds in the Equity Portfolio?
Once we have decided on the no of funds we wish to own-say 3 equity funds then the next question is how many of these three should be large cap, small cap, or mid cap equity funds. Again, there is no one shoe that fits all solutions. It would depend on the individual’s risk appetite, outlook, return expectation and time horizon. If you are risk averse, it is better to stick to large cap funds, hence you could own three large cap funds. But if you intend to invest for the long term and are ready to take that higher bit of risk, you could add one mid or small cap fund. So, in this case, you can hold 2 large caps and one mid or small cap fund. If you are one of those who has a high-risk appetite and are looking to maximize returns, you can invest in 2 midcaps and one small cap fund. Please note that over a longer run mid & small cap funds have beaten large cap funds by about 2-3%. However, these are more volatile and could deliver sharp underperformance in the short term. So, one should carefully evaluate risks before deciding this allocation.
- Asset allocation is important-do your asset allocation before deciding on the number of funds.
- Do not invest 100% into one asset class, diversify between equity, debt, and gold.
- Ideal number of funds to hold is 4-5.
- Beyond 5 funds, returns could be average due to overlap of stocks held in the portfolio.
- Among these 5 funds, decide on which type of funds basis your asset allocation.
- Keep monitoring your portfolio at least once or twice a year and rebalance it if necessary.