Tips to diversify your mutual fund scheme portfolio in similar fund categories

Zeus, an IT expert working in Company A, used to save Rs 15, 000 from his salary every month. He deployed Rs 5,000 each in three mid-cap schemes such as Axis mid-cap fund, Baroda mid-cap fund and PGIM mid-cap opportunities fund based on their past returns performance. Each of these schemes had outperformed the benchmark in the three-and-five-year return category. Zeus was well aware that the schemes entailed a lot of risk and he could bear heavy losses if adverse market conditions occurred.

However, Zeus used to select the schemes based on past performance alone and always remained under the impression that his portfolio was well diversified i.e. all eggs were not in one basket. So, his understanding was that each of these schemes was composed of different companies and sectors and there were no overlaps. However, he was not aware and did not check whether that was true.

One day, Zeus’s friend, Madeline, an investment professional was visiting him and asked him casually, “How are your investments performing, you were investing Rs 15, 000 every month”. To this, Zeus replied, “I have invested in three mid-cap schemes which have more than 18 per cent returns, outperform the benchmark and are well-diversified”. Madeline asked him, “Have you seen the sectors in which these schemes invest and the companies that constitute these schemes”. Zeus replied, “Not really, but each scheme has more than 40 different stocks; they invest in different sectors such as financials, technology, etc; what is the worry.” Madeline said, “Let us collate the sectoral and portfolio disclosure of these schemes.”

A quick collation of scheme information will help us understand if the portfolio is truly diversified. Upon collation Madeline said, “Zeus these three schemes have more than 40 per cent exposure to Financials, Technology and Chemicals sector.” (Refer Table 2).

Madeline went on to add, “Diversification reduces chances of losing money by investing money in different instruments such as stocks, debt etc. It means you don’t put all your money in one sector. For example, you don’t put all your money in the banking sector i.e. financials. You want a good mix of sectors i.e. financials, real estate, chemicals, technology, FMCG etc. The main aim is to maximise returns by investing in different sectors so that one would not lose all their money if something bad happened in a particular sector or to a particular company. For example, when covid-19 occurred, all sectors and companies were affected adversely, but some sectors and companies were less affected than others.”

Thereafter, she said, “Top 25 companies form 60-70 per cent of each of the schemes portfolio and 14 companies are common among these schemes i.e. ICICI Bank, Coforge, Mphasis, Sona, etc.” (Refer Table 3).

Madeline explained to Zeus that under these schemes he has an exposure to 14 companies that formed 20.20 per cent of their Total AuM. Thereafter, she told him, “To diversify a portfolio you should consider whether these schemes choose same companies or same sectors or not. The problem is that you only have mid-cap companies which is a universe of 150 odd companies in India. Your mutual fund scheme offerings are bound to be heavy on financials, technology and chemicals sector. You should select a small-cap or large-cap scheme as well which will help obtain different sector and company exposures.”

This made Zeus realise that portfolio diversification doesn’t always mean 40 or more stocks but a suitable mix of diverse sectors and companies across large-cap, mid-cap and small-cap.

(The writer is Assistant Professor – Finance & Accounting, FLAME University)