Explained: Diversification between different Mutual Fund schemes & AMCs

What is diversification in the context of investment planning?

Diversification is one of the important tools of investment planning because it helps to reduce the overall risk in your portfolio. As you know, it is very important to diversify your portfolio into various asset classes for the sole reason that not all the assets move in the same direction. In case you have a good risk appetite and have already invested in equities, you should also get exposure to other asset classes like Gold, Debt, FDs, PPF, PF or Real estate in order to reduce the overall risk of just having one or two asset classes and a potential threat to your portfolio returns if that asset class does not perform. This however, has to be done prudently based on your goals, risk appetite and overall financial assessment.

What is diversification with respect to mutual funds and the goal it should achieve?

To put it simply, diversification with respect to mutual funds investments is nothing but deciding which MF schemes to invest in like debt funds or equity funds and then further diversification in terms of selecting large cap, mid cap, small cap or a sectoral fund to serve the main purpose of investing in the mutual funds at the first place itself.

Now, what goal should this diversification serve? Well, it really helps in achieving various goals. For example, you can diversify and invest in a new asset class like debt or equity. Then it can help you to use and benefit from the individual management effectiveness and process of a particular manager or a fund house. You can use multi cap funds or sectoral funds to generate alpha i.e. additional returns in your overall portfolio returns by taking that extra risk and all these can be achieved by using diversification.

How much diversification is needed?

This is a billion dollar question. It is like we all know the fact that one should not put all your eggs in one basket, but does it mean that we should have a separate basket for each egg? Absolutely not, isn't it? It has been observed and seen that many times investors kept on adding more stocks or mutual fund schemes on an impromptu basis under the belief that they are actually diversifying their portfolio. No, it is not diversification and remember the fact that by having too many funds in your portfolio you may lose much but you may also not stand to gain either, in fact it will be difficult to manage a big portfolio.

Generally, 6 to 7 funds are more than enough to provide the good amount of diversification, only in case where your portfolio size is too big, you may think of adding a couple more. For example, if you decide to invest say 20% of your money to a large cap fund then don't invest in 2 or 3 large gap funds, you can simply invest in one large cap fund because for the simple reason that by adding more funds to your kitty, there is no additional diversification which is achieved, rather you may end up investing in all the stocks as given in the universe which makes your fund a passive one like an index fund.

Should you diversify in different mutual fund houses also?

Having understood the importance of diversification and after finalising your scheme allocation i.e. for example say 30% in large cap, 30% in mid cap, 20% in multi cap and 10% in small cap and remaining in balanced fund, now would you go on buying respective schemes from the same fund house or allocate these investments in different fund houses because by default, diversification was already built in the mutual funds as an investment tool itself. What should you do?

As such there is no standard rule and it is completely depends on your financial goals and plan. It may not be necessary to invest across fund houses but it is surely one of the safe and good practices to do the same.

There are multiple reasons behind investing in different AMCs as follows:

Unique style and processes: The reason to invest in different fund houses will reduce risks. Each fund house will have its own style of managing money, its unique investment process and by investing in more than one fund house, you thereby protect yourself against any potential change in their process or rather failure in the process. 

Top Performing Funds: It is not always that you will find a fund house topping the list of best mutual fund schemes across all the categories, so diversification between fund houses gives you the advantage of investing in the best schemes of a particular fund house based on the past track record and an eye on the future. 

Fund Manager: Many times the same fund manager manages multiple funds and it is very common for a person to change his or her job or getting retired or change in their internal team or roles etc. If that happens, then the new manager who takes over the fund may not be able to match the style of his predecessor and your investment can be at a great risk.

Major Change in the constitution: One more important factor is the major change in the structure of the AMC like merger, demurrer or any other regulatory compliances which can affect the fund house adversely or impact the performance of their schemes.

Case Study:

Mr Kamesh is 40 years old and has existing SIPs in the following mutual fund schemes: Franklin India High Growth Companies Fund and Franklin India Smaller Companies Fund - Rs 4,000/month, ICICI Prudential  Focused Bluechip Equity Fund and ICICI Prudential Value Discovery Fund - Rs 5000/month, ICICI Prudential Select Large Cap Fund - Rs 3,500/month. He is ready to invest another Rs 4,000 more per month. His query is that he has shortlisted Franklin India Prima Fund & Franklin Build India Fund and he wants to know whether his my choices of funds is correct? Should he go ahead with his investments in these two MFs?  Another fact is that, he can take high risks with respect to his investments in MFs.

Answer: His existing portfolio is well diversified, considering the fact that he can take high risk, I would suggest him to also look out for a few other good funds in the mid cap & small cap category. He can invest in Mirae Emerging Bluechip, L&T India Value Fund or Emerging Businesses. Since he already has three of Franklin & ICICI funds in his portfolio, adding another Franklin will make his portfolio heavily dependent on one AMC and puts him at a potential risk in case of any major changes which may happen in the management team of that particular AMC or it can be any other regulatory reason as well. In that case, his portfolio stands to get hit adversely. Try to avoid too many funds from the same AMC unless you are bullish and willing to take that risk, then you can always invest in the same AMC with the potential risk as explained.