How to Reduce the Number of Schemes in Your Mutual Fund Portfolio

February 4, 2022 Mutual Fund

‘Less is more’ is an unprecedented trend that has been gaining a lot of momentum. The concept of less is more is based on the value of simplicity and clarity, which implies that having less can help you add more value.

The same principle can be applied when you build your mutual fund portfolio by keeping it simple and clutter-free. As you know, Mutual funds have gained acceptance among investors as a potent tool to achieve diversification and maximise wealth. However, many investors are not sure about the right number of mutual fund schemes they should hold in their portfolios to achieve their financial goals. Consequently, investors often end up accumulating over 15-20 mutual fund schemes in their portfolio.

While there is no thumb rule on the number of mutual fund schemes one should have in their portfolio, it is important to note that over-diversification is counter-productive to creating wealth.

As the saying goes, “Too much of anything is good for nothing”.

This means, beyond a point, every scheme you add to your mutual fund portfolio…

• Just occupies a place in your portfolio
• Offers no extra benefit
• Doesn’t help lower the risk
• Increases the burden of monitoring
• Discourages optimum use of resources

Mutual fund schemes, by nature, hold a well-diversified portfolio of securities to reduce the stock/sector-specific risks, so it is pointless to add too many schemes to achieve optimal diversification. Therefore, by limiting the number of funds in your portfolio you can lower the portfolio risk, earn optimal returns, and ensure stability in performance.

Most individual investors require not more than 5-10 mutual fund schemes, depending on the size of the portfolio. These would include schemes across equity mutual funds, debt mutual funds, hybrid mutual funds, and ELSS funds. If you are investing a modest amount every month, even 3-4 schemes may suffice to create a well-diversified portfolio.

If you are holding too many schemes, here are some helpful ways to reduce the number of mutual fund schemes in your portfolio:

1) Redeem schemes that do not align with your financial goals

Many investors keep adding mutual fund schemes to their portfolios either driven by emotions, or influenced by peers/family, popularity of the fund, star rating, top performers of the recent past, etc., hoping that it will help the portfolio to deal with volatility. However, such investment may not always align with your risk profile, financial goals, or overall asset allocation plan. If you clearly define your financial goals, investment horizon, and risk profile, it will help you to create a focused portfolio. You can start by quantifying your goal that will help you identify the most suitable scheme (equity, debt, etc.) in line with your risk profile and investment horizon. For instance, if you have a time horizon of less than 7 years, redeem high risk schemes such as Small-cap funds and Sector/Thematic Funds. At PersonalFN, we have time and again cautioned investors to stay away from Sector/Thematic funds. We believe that investors are better off investing in diversified equity mutual fund schemes that have meaningful exposure to various sectors.

2) Remove schemes with overlapping investments

If you hold multiple schemes within the same category, it is likely that they have invested in the same set of stocks with similar strategies. In which case, it will not add much value to the portfolio. For instance, if you own 3-4 Large-cap funds, it is unlikely that all of them will turn out to be outperformers, and you may end up earning returns in line with the market. The higher gains in 1-2 schemes may get nullified by lower returns in other schemes. This defeats the purpose of investing in actively managed schemes that usually charge a higher expense ratio to generate alpha. Consider adding more schemes within the same category only if they follow distinct investment styles or strategies.

3) Have an optimal asset mix

The right asset allocation mix is essentially about adopting an investment strategy that can balance your portfolio’s risk and reward, keeping in mind your risk profile, financial goals, and your investment time horizon. It is important that you invest in mutual funds as per your asset allocation plan. Equity mutual funds are ideal for investors with a high risk appetite and long term goals that are at least 3-5 years away. On the other hand, debt mutual funds are suitable for short to medium-term goals and for adding stability to the portfolio. So, for instance, if you have an investment horizon of less than 3-5 years, you don’t need too many equity schemes in your portfolio. Therefore, when your goal is nearing, you can gradually trim allocation to riskier categories such as Mid-cap Funds and Small-cap Funds and shift to less risky categories such as Large-cap Funds, Flexi-cap Funds, and Hybrid Funds. Subsequently, phase out all pure equity mutual funds and move to debt mutual funds and other relatively stable avenues such as Bank deposits.

4) Eliminate consistent underperformers

Consistent underperformance of a mutual fund scheme relative to the category peers and the benchmark index is an important signal for you to consider moving out of it. The scheme that you have invested in should be capable of limiting the downside risk during bearish phases by falling less than the benchmark and peers, and generating higher returns than the market during bull phases. However, do not judge the scheme based solely on its short-term underperformance, say 6-months, 1-year, etc. Also, avoid comparing the performance with a scheme belonging to another category.

To check whether the scheme is a consistent performer, analyse it on various risk-reward parameters such as, returns over various time frames, performance across market phases and cycles, Sharpe Ratio, Sortino Ratio, Standard Deviation, etc. While determining the consistency of a scheme’s performance, also lay emphasis on its quantitative parameters such as the portfolio characteristics of the scheme, the efficiency of the fund house, and the quality of the fund management team.

5) Cut down adding NFOs

Often investors add many new fund offers (NFOs) in their portfolio buoyed by its sales pitch or fear of missing out. However, you should avoid adding NFOs to your portfolio. When you invest in an NFO, there is no reliable track record of the fund’s performance, portfolio quality, risk-return profile, etc., that will help you determine if it is a worthy scheme for your portfolio. This makes NFOs a risky proposition for investors, and you would be better off cutting down on NFOs.

Preferably, invest in a diversified portfolio spread across categories, sub-categories, and investment styles and stick to it until your goal is achieved. That said, if you are willing to take the risk, you may consider adding NFOs to your portfolio, provided they offer a unique proposition that is currently not available in the market and if it aligns with your financial goals.

Things to consider when you offload schemes from your portfolio

If you are looking to offload mutual funds in your portfolio, do so in a gradual and systematic manner to reduce the impact of loads and taxes. Most mutual fund schemes impose an exit load if the investment is redeemed (including switches) within one year. Second, you may be liable to pay capital gain tax on the gains made on redeeming an investment. Furthermore, you may accrue losses on redeeming your mutual funds depending on the market conditions.

In case of equity mutual funds, long term capital gain tax will apply at the rate of 10% if redeemed after one year (only on gains of over Rs 1 lakh in a financial year), whereas short term capital gain tax of 15% will apply in case the investments are held for less than a year.

For debt mutual funds, investment of more than three years is considered as long term, and the gains are taxed at 20% (excluding surcharge and cess) with indexation benefit. In case of investments of less than three years, the gains are considered as short term and taxed as per the investor’s income tax slab rate.

To conclude

Adding too many mutual fund schemes to your portfolio can make the crucial task of monitoring your portfolio a challenging exercise. You may even end up with a portfolio consisting of underperforming schemes, schemes with overlapping investments, or an unsuitable asset mix.

Therefore, ensure that you include only those schemes in your mutual fund portfolio that align with your financial goals and personalised asset allocation plan. Avoid adding too many risky funds to maximise your returns.

Review your portfolio periodically (at least once a year) to see if it is well placed to achieve your goals. When you review the portfolio, check whether there is a need to weed out the underperforming schemes and replace them with a more suitable alternative. Also, check if there is a need to rebalance the portfolio so as to align it with your personal asset allocation plan.

This article first appeared on PersonalFN here