Mutual Fund Diversification: Meaning, How it Works and Advantages (2024)

Diversification is a risk management technique that you can use to reduce the risk of investing. In diversification, you spread your investment across different securities, asset classes, and industries. The primary idea behind this is to negate the downside risk of one security with another so the overall portfolio returns are maintained. So, a diversified portfolio will include different asset classes such as equity, debt, government securities, commodities, or currency. However, it is also important to diversify within an asset class. If you decide to invest in mutual funds, you must ensure that your mutual fund portfolio is diversified.

What is mutual fund diversification?

Diversification in mutual funds means spreading out your investments to lower the chances of losing money. It’s like not putting all your eggs in one basket to reduce risks. Investing in mutual funds to build wealth is an excellent idea. This is because equity mutual funds have the potential to give high returns in the long term. Moreover, mutual funds invest in several companies, which automatically ensures diversification. Another advantage of investing in mutual funds is that they spare you the effort of picking individual stocks.

However, investing in just one mutual fund doesn’t mean your portfolio is diversified. Imagine if that one mutual fund you invested in started giving losses; all your hard-earned money would vanish right in front of you. Hence it is important to diversify your mutual fund portfolio as well.

How does diversification work in mutual funds?

There is always a risk of underperformance when it comes to investing. Since mutual funds invest in marketable securities and are managed by fund managers who base their decisions on research and assumptions, there is a higher risk of a fund underperforming when compared to the market of other funds.

Hence it is important that you spread your investment across multiple mutual funds, so you can reduce the downside risk and maintain the overall portfolio return. When you invest in multiple mutual funds with different portfolios, and time horizons, the loss in one mutual fund can be nullified with the profit from another mutual fund. However, for this to work, it is important to invest in mutual funds that are not correlated.

This means you must invest in mutual funds spread across different industries, geographies, and time horizons. For example, if you invested in a fund which is the majority of the exposure to travel companies, then in times when inflation is high, the profit margins of these companies might contract, affecting the performance of the fund. If you invested in a fund with major exposure to commodities, then the profit from this fund can negate the loss of the first fund.

Hence with mutual fund diversification, you can reduce the downside risk and maintain your portfolio returns, which ultimately will help accumulate wealth in the long run.

How to diversify your mutual fund portfolio?

To have a diversified mutual fund portfolio, you must carefully choose funds with exposure to diverse securities. The following points will guide you in diversifying your mutual fund portfolio.

Diversify across different schemes

Mutual funds are broadly categorized into equity, debt, and hybrid mutual funds, and each of these categories has different types under them. For example, equity funds are divided into large cap, mid cap, small cap, value funds, and thematic funds. Debt funds are divided into liquid, ultra-short-term, credit-risk, and long-duration funds. Finally, hybrid funds are divided into aggressive, conservative, and balanced funds. Investing across several types of mutual funds will ensure your portfolio is well diversified.

Diversify across time horizons

Invest in mutual funds with different time horizons. Equity funds, by default, are a long-term investment option and suit a horizon of more than five years. Debt mutual funds, on the other hand, are suitable for shorter horizons. You can use hybrid funds for a duration of three to five years. So, spreading your investment across different time horizons will reduce the impact of market volatility on your portfolio.

Diversify across different fund managers and fund houses

Mutual funds are managed by fund managers who are professionals with expertise in their field. They use different strategies for selecting securities for a mutual fund. However, not all fund managers can deliver high returns. Hence it is important to choose mutual funds managed by different fund managers. Moreover, it is important to select different asset management companies (AMC). If any fund house commits a mistake or willfully defaults investors, then you might end up losing all your money. By spreading your investments across different AMCs, you can ensure the risk of investing in one fund house reduces.

Diversify across different benchmarks

Fund managers decide on the objective of a fund and then choose an appropriate benchmark for it. This benchmark acts as a standard metric to measure the performance of the fund. The market has different benchmarks, such as Nifty 50, BSE Smallcap, Nifty Midcap 100, Nifty Bank, etc., that depict different industries or different market capitalizations. By choosing funds based on different benchmarks, you can invest across multiple industries or market capitalization, which ensures enough diversification.

Types of Diversified Mutual Funds

Mutual funds have two extremes where some are diversified, while others are extremely concentrated. For example, sector funds, thematic funds, or focused funds invest based on a theme or sector. On the other hand, there are multicap funds and hybrid funds that offer enough diversification that can help you diversify your entire portfolio. Below are the different types of diversified mutual funds.

Hybrid funds

Hybrid funds invest in both equity and debt securities. They strike a perfect balance between high return and low risk as they invest across asset classes. There are seven subcategories of mutual funds under the hybrid category, namely conservative hybrid, balanced hybrid, aggressive hybrid, dynamic asset allocation, multi-asset allocation, arbitrage, and equity savings funds. All these can help you diversify your mutual fund portfolio.

Multicap funds

Multi-cap funds are open-ended equity mutual funds that invest at least 65% of total assets in equity spread across large-cap, mid-cap and small-cap funds. The fund manager has the freedom to decide the asset allocation of the fund based on market conditions. By investing across all market caps, the risk is balanced. Moreover, the potential of earning high returns is greater as the fund also invests in small and mid-cap stocks.

Large and mid-cap funds

Large and mid-cap funds are equity funds that invest in both large and mid-cap stocks. They invest a minimum of 35% of the assets in large-cap and a minimum of 35% in mid-cap stocks. Though they are slightly more risky than pure large-cap funds, they are well diversified and have a higher potential to earn good returns in the long term.

Value funds

Value funds are diversified mutual funds that invest in undervalued stocks. The fund follows a value investing strategy where the fund manager picks stocks based on their intrinsic value. These stocks have strong fundamentals and are valued lower than their intrinsic value, and hence have a lower downside. Value funds invest across market capitalizations and industries and hence are diversified mutual funds.

Advantages of investing in diversified mutual funds

The following are the benefits of diversified mutual funds.

• Access to a wide range of securities: By investing in diversified mutual funds, you can get access to a wide range of securities spread across different market capitalizations, sectors, themes, and geographies. By just investing in one or two funds, you can invest in a variety of securities which is not possible if you invest in any other security such as equity shares or bonds.
• Acts as a cushion during market volatility: During market downturns, a diversified portfolio will help reduce the risk. As the portfolio is spread across different market capitalizations and industries, the profit from one sector can nullify the losses from another.
• Helps investors use multiple investing strategies: Diversified mutual funds use different investment strategies, such as growth or value investing. For example, multi-cap funds use growth-oriented strategies and value funds use value investing strategies. Hence by investing in diversified mutual funds, you can get exposure to different investing strategies.
• Monitoring portfolio is easy: A diversified portfolio doesn’t need to be monitored regularly, even during market downturns. Although fund managers take care of a fund’s portfolio, even investors need not rebalance their portfolio regularly.
• Helps achieve financial goals: The ultimate goal of investing in a diversified portfolio is to achieve financial goals. By lowering the downside risk, the portfolio returns are maintained, which helps accumulate wealth in the long term and achieve all your financial goals.

Things to consider before investing in diversified mutual funds

Before investing in diversified mutual funds, you must keep in mind the following.

• Financial goals: The first thing that you must do before considering investing in diversified funds is to assess your financial goals. Diversified funds best suit long-term financial goals such as retirement or a child’s college fund. This is major because these funds have the potential to yield higher returns in the long term due to their diversified portfolio.
• Investment horizon: As mentioned above, these funds suit long-term goals. In the short term, the returns from these funds are volatile and can fluctuate a lot. Hence for goals above the tenure of five years, you can consider diversified mutual funds.
• Risk tolerance level: Diversified mutual funds are not immune to risks. Hence if you are someone with low-risk tolerance levels, then you should consider low-risk funds such as debt. However, if you have a very long-term horizon (above five or seven years), you shouldn’t miss out on these funds as, in the long term, the volatility smoothens out.
• Fund’s objective: Before investing in diversified funds, check their objective. The fund’s objective tells how the fund manager will invest in different asset classes to make the desired returns. Align your goals with the fund’s objective to find the perfect fund that suits your goals, resources, and needs.
• Expense ratio: Diversified funds, like other mutual funds, charge a small fee. This fee is directly deducted from the net asset value (NAV) of the fund and hence affects the profits. So, when choosing a fund to invest in, you must compare the expense ratio of different funds and pick the one with the least expense ratio.
• Performance: When choosing funds for your portfolio, you must assess its performance. Although past returns do not guarantee future returns, studying them will give you an idea of how the fund reacts to different market conditions. Choose funds that consistently perform better than their peers and the benchmark. This is because a fund that has performed well in the past has a high chance of performing well in the future as well.
• Risk: Mutual funds are market-linked investments and hence are exposed to market risks. Although they have lesser risk than pure equity or thematic funds, you must assess the risk ratios of these funds. You can look at the beta, standard deviation, and Sharpe and Treynor’s ratio to measure their risk-adjusted performance.

Difference between diversification and over-diversification

Although diversification with mutual funds is easy, there is always a risk of over-diversification. Over diversification is a scenario where you have invested in a large number of funds which makes it difficult to manage them. Moreover, there is always a risk of investing in similar stocks or sectors in over-diversification. This will actually drag the portfolio returns down, lowering the overall risk.

Hence it is important to diversify right. In other words, it means investing in an ideal number of funds will ensure optimal diversification. A maximum of five funds in a portfolio will ensure your mutual fund portfolio is diversified. Anything more can lead to over-diversification.

Try to pick one or a maximum of two funds in a category. For example, invest in one or max two small-cap stocks. Next, check if the portfolio of these two funds is different. If it’s the same or even similar, there is no point in investing in two funds. You must also do regular portfolio reviews to check for any overlaps in your portfolio. Doing all this will ensure your portfolio is optimally diversified, and you can avoid the risk of over-diversification.

Frequently Asked Questions

How many SIPs should one have?

Investing in a maximum of five mutual funds is considered ideal for any investor. This way, your portfolio will be diversified. Anything more will lead to over-diversification.

How much diversification is enough in mutual funds?

Mutual funds are diversified in nature. However, it is important to invest across multiple mutual fund categories. You can invest in a maximum of five funds to ensure your mutual fund portfolio is well diversified.

What is the danger of over-diversification?

Over-diversification can reduce the overall portfolio returns and increase the risk of investing. This is because investing in too many mutual funds can lead to similarities in a portfolio which can bring down the return in a volatile market condition. Moreover, managing an over-diversified portfolio can be difficult.

How do I diversify my portfolio?

You can diversify your mutual fund portfolio by investing across market capitalization, sectors, and themes. For example, you can invest in large-cap, small-cap, and mid-cap funds as they invest across industries. You can also invest in multi-cap funds and debt funds or hybrid funds to invest across asset classes.