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Harry Markowitz, the renowned Nobel Prize-winning economist, once said that diversification is the only free lunch in investing. So, what did he really mean? And how can you and I have this free lunch? Let's discuss what diversification means in the context of mutual funds.
Markowitz meant that diversification is an insurance against volatility and risk. Some companies die, they fail, but your portfolio survives due to diversification.
In the context of mutual funds, what does diversification really mean?
If you've chosen to invest via mutual funds, you can approach diversification in a couple of ways. You can choose a flexi-cap fund, where the fund manager decides how to allocate assets. You could also opt for an aggressive hybrid fund, where your money is split between fixed income and equity investments across various sectors and company sizes. This diversification helps optimise returns, spreading risks and enhancing potential gains. As your investments grow, you might allocate funds to multiple managers, meaning you can invest in multiple funds to mitigate any subpar performances by individual managers over time.
That said, aggressive hybrid fund, flexi-cap fund, multi-cap fund, large & mid cap fund, value-oriented fund and tax-saving funds are all diversified vehicles. They are designed to remain diversified at all times.
Then there are narrower categories: large-cap funds, which are also diversified and invest in big companies only, and small-cap funds invest in small companies and are diversified too. Here, you have to be tolerant of extreme volatility. A small-cap fund will be more volatile. In bad times, they will crumble. If you're fine with it, you can choose a mid-cap fund, a small-cap fund, and a large-cap fund and have greater control. You can also opt for an index fund instead of a large-cap fund.
So, let's delve deeper into multi-cap, flexi-cap, and large & mid cap funds. If someone wants to diversify, how do these funds compare?
SEBI's definition for mutual funds is that the top 100 companies by capitalisation are large-cap, the next 150 are mid-cap, and all others are small-cap. Based on this definition, mutual fund categories are set up.
Flexi-cap funds have great flexibility to invest wherever they want, with no restrictions. They are go-anywhere funds, investing in large-cap, mid-cap, or small-cap stocks of their choice. They claim to invest opportunistically in any category. But as flexi-cap funds grow larger, investing in small-cap and mid-cap stocks becomes difficult, so many large flexi-cap funds have small allocations to mid and small caps and are dominantly large-cap funds. They have lost on performance because of this.
The difference between flexi-cap and multi-cap funds is crucial. Flexi-cap funds invest in large, mid, and small caps in any ratio they choose. Multi-cap funds must have 25 per cent each in large caps, mid caps, and small caps at all times, with flexibility only for the remaining 25 per cent. This enforced discipline tends to drive superior performance over time.
Which fund type suits which investor profile?
There's a hierarchy of sophistication that investors gain over time. As a new investor, start conservatively with flexi-cap funds. They are conservatively run and provide flexibility. Avoid mid-cap and small-cap funds initially. Most people should graduate from flexi-cap funds to multi-cap funds to optimise returns with the enforced discipline of 25 per cent allocation to large, mid, and small-cap stocks at all times. This tends to be more rewarding over time. So, start with flexi-cap, then move to multi-cap, and ignore other categories initially.
How do you get optimum diversification? How many funds should you have in your portfolio?
For an investment of Rs 5000 to Rs 25,000, one multi-cap fund will suffice. Once your allocation grows to Rs 5 lakh, consider another fund. When your portfolio crosses Rs 25 lakh, add a third fund. This method reduces the risk of poor performance by a single fund manager. There is no hard and fast rule; just avoid adding funds randomly. Have three or four funds for sufficient diversification. Don't have too many funds, as it becomes unmanageable and you end up with an index fund's performance while incurring higher costs.
What about geographical diversification?
Right now, it is difficult for Indian investors to invest abroad, but when permitted, do so. Diversifying internationally helps you de-risk and seek new opportunities. Owning foreign stocks adds promise and de-risks your domestic investments.
Viewer's question
Ram Dittakavi asks: 'I invest in mutual funds recommended by Value Research only for my retirement. What benefits do active equity funds recommended by Value Research have over investing in an NPS Tier 2 account, which seems to have better taxation and fund management charges?'
Answer: Nothing can match the low cost of NPS Tier 2-lower costs and superior performance. However, their investment universe is limited to the top 200 companies. The Indian equity market offers opportunities beyond the top 200. For a long-term investor targeting retirement, the differential returns between small-cap, mid-cap, large-cap, and index funds can be significant. Combining NPS Tier 2 with small and mid-cap funds provides a diversified portfolio.
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