How many funds do you have in your portfolio?
2, 4, 10, 20 or even more? Is that a problem?
What is the problem with too many funds in the portfolio?
With fine MF software at disposal, analysing or dissecting a portfolio with too many funds is not that complicated. But a bigger problem is decision-making.
A portfolio with many funds is difficult to manage. It makes decision making difficult. It causes decision paralysis too. If poor performance of a fund does not affect your portfolio meaningfully, you will likely not touch that fund. You will remain stuck with such insipid investments forever.
By the way, “Too many” is subjective. For some, even 3-4 is too many. For others, no number is too high. I am fine with holding funds as long as each fund serves a purpose in the portfolio and has a meaningful allocation. Well, let us not get stuck with this.
The real question is, what to do if YOU feel you have too many funds in the portfolio? How do you reduce the number of funds? Which funds to exit? Which ones to keep?
However, before we get there, let us first see why we have this problem in the first place.
Why do we have many funds in the portfolio?
There are a few investors who just cannot imagine being in a poor performing fund or NOT being in the best performing fund. They are just too worried about, “What if my fund does not do well?”. So, even if they must invest Rs 1 lac in ELSS for tax-saving, they will split the amount in 4 ELSS funds. Such investors are difficult to convince.
However, most investors do NOT start with many funds. The number of funds usually increases with time. You start with Fund A and Fund B. After a few years, you realize Fund C and D are flavour of the season. You stop investing in Funds A and B and start investing in Funds C and D.
Now, while you are routing incremental funds to C and D, you still retain funds A and B in the portfolio.
And it is not just about chasing performance. Your thought process might change too. Today, you are bullish on large cap funds or say the pharma sector. You add a couple of pharma funds to the portfolio. After a few months, you start liking the prospects of IT sector or midcap stocks. You add a couple of IT and midcap funds to the portfolio. Then, banking stocks or small cap stocks. The number of funds keep rising.
There is nothing wrong per se in adjusting your portfolio according to your outlook. The problem is that most of us do not get the timing right. You do not want to move into a sector that starts underperforming once you get in. However, doesn’t that usually happen? Money chases performance. If a particular sector or fund is doing well, the investors start routing more money towards those sectors or funds. Eventually, the mean reversion sets in and the performance is usually much below expectations.
From the point of view of number of funds in the portfolio, the problem is that once a fund gets in, you do not throw it out. Irrespective of how the fund is performing or how you think about the underlying stocks, such funds do not ever find their way out.
Firstly, the inertia.
Secondly, you do not want to exit a fund until you have at least broken even. You do not want to book loss. And when the fund eventually breaks even, it is doing well. And you want to hold on for a while to ride the good performance.
Thirdly, exiting the old funds is a decision. And any decision challenges you with “What ifs”. What if the Fund A starts performing well immediately after you exit the fund? And this might actually happen. And nobody wants to live with regrets. Better still, don’t do anything and let the funds be in the portfolio.
You repeat this cycle a few times. And you have 12-14 funds in the portfolio.
This is just for equity funds. You need debt funds too in the portfolio.
How to reduce the number of mutual funds in the portfolio?
#1 Remove any fund whose exposure is less than 5% of the portfolio
This is a low hanging fruit. If a fund is less than 5% of the portfolio (talking about equity funds) and you are not even adding to the fund, you must exit such fund. And do that ruthlessly.
Reason: Since you are not adding to this fund, this investment will likely become smaller and smaller portion of the portfolio. As the percentage allocation goes down, the ability of a fund or investment to impact overall portfolio performance goes down sharply.
Even if this small portion (allocation) does remarkably well, it wouldn’t move the needle for your portfolio. In other words, the impact on your portfolio will not be meaningful.
Therefore, to keep portfolio simple, exit small (and meaningless) allocations in the portfolio. So, if you invested Rs 5,000 to a pharma fund 3 years back, it is time to exit that investment, irrespective of performance.
Consider exit load impact and capital gains tax implications before exiting.
#2 Each fund in the portfolio should serve a purpose
4 large cap funds in the portfolio will not add much value to the portfolio. You can expect a lot of overlap of stocks in the portfolios of these funds. It is likely that not all 4 will be the best or worst performing large cap funds. With 4 large cap funds, you will get middling performance. For such performance, you are better off putting your money in a simple large cap index fund. And its low cost too and eventually costs weigh on your portfolio performance.
Thus, if you own 5 midcap funds or 7 small cap funds, you must rethink your portfolio strategy. Investing in 5 midcap funds is not diversification. It is confusion. Avoid holding many similar funds in the portfolio.
Pick up one or two midcap funds (using any criteria) and consolidate midcap portfolio in the selected funds.
Decide the portfolio structure first. Say, 50% large cap, 30% midcap and 20% small cap (This is not a suggestion). And then pick up funds to fill the structure. Not the other way round. With such structure, your fund selection will be more thoughtful and will have greater purpose.
OR if you want to make more colourful investments, think in terms of core and satellite portfolio, and decide allocation to each portfolio and sub-allocations within each portfolio. Say, 50% to Core portfolio with equal exposure to domestic and international large cap indices. And the remaining 50% to satellite portfolio built with exposure to midcap (25%) and sectoral/thematic funds (25%).
#3 Before you declutter your portfolio, you need to declutter your mind
For you to keep your portfolio simple and small, you must first believe in the power of a simple portfolio. Trust me it is not easy.
There are a few investors who simply have a couple of diversified index funds in the portfolio. If you are such an investor, you are happy and content. You ignore noise, which is aplenty in the financial services space. You do not care about the theme, sector or the fund which is in vogue today. You are not jealous if your cubicle-mate has earned 15% in the past 1 year while your fund has given only 10%.
You do not expend energy on selecting the best performing theme or fund. With this, you can focus on more important aspects of asset allocation and portfolio rebalancing. More importantly, asset allocation and portfolio rebalancing are also the aspects you can control. You do not control how a fund performs after you have invested.
For most retail investors like you and me, this is important from portfolio performance perspective too. We are usually late to any party. By the time a sector or theme attracts our attention, it has usually already run its course.
It is not that you can achieve this discipline with only passive index funds. You can do this with actively managed funds too. Just that you must understand that the baton of the best performing funds keeps changing. No actively managed fund (or any investment strategy) does well all the time. There will be periods of underperformance and outperformance. You need to give your investments a longer rope?
And that’s where things become complex. How do you know whether the recent bout of underperformance in your active fund is temporary or will continue for a much longer time? Nobody knows this. You cannot trust AMC or the fund manager commentary on under-performance. That is just post-mortem, fancy forecast, and glib talking. This has zero value and will help little in your decision-making. So, you must have a very objective exit criterion. Say, 3-year or 5-year underperformance to benchmark or anything else.
With such a process, your equity fund portfolio will be simple, concise, and easy to manage.
While I surmise the benefits of reducing mutual fund schemes in the portfolio, my own record for my portfolio and my investors’ portfolios has been mediocre. And the reason was primarily the evolving thought process. Initially, there was a heavy reliance on actively managed funds. Now, the focus is more on passive investments (both market-cap-based indices and factor-based investments). With better clarity about the desired portfolio structure and the choice of funds, I have been able to simply most equity fund portfolios. With debt funds, however, things have been relatively complicated because of the 3-year holding period for long-term capital gains and unique cash flow requirements of the investors. That MF redemptions work on a FIFO basis (First-in First-out) also poses challenges (can be managed using multiple folios for the same fund). But I just prefer to work with more debt funds in the portfolio. Gives me greater flexibility in addressing investor cash flow requirements. A work in progress.