Friday, September 12 2025
Source/Contribution by : NJ Publications

"Don't put all your eggs in one basket" - every investor has heard this advice. For mutual fund investors, this often translates to holding a large number of schemes, believing that a portfolio with ten or more funds is automatically well-diversified. But what if this is a costly illusion?

The Diversification Illusion

Simply accumulating multiple funds doesn't guarantee true diversification. In many cases, it can lead to portfolio overlap, where different funds hold many of the same underlying stocks, leading to a concentrated portfolio rather than a diversified one. This can amplify risk and make your portfolio more vulnerable to market downturns. So, how can you build a genuinely resilient portfolio that protects you from the illusion of diversification?

What Real Diversification Looks Like

A truly diversified mutual fund portfolio balances different asset classes, investment categories, and styles so that when one part underperforms, another cushions the impact.

1. Diversification at the Asset Allocation Level

The most critical decision you will make is how to allocate your capital. Your portfolio should be a strategic blend of assets that have low or negative correlation with each other. A good portfolio should have exposure to:

• Equity (Shares / Equity Mutual Funds) - Growth-oriented, higher risk, suitable for long-term needs.
• Debt (Bonds, Debt Mutual Funds, FDs) - Provides stability, regular income, and reduces volatility.
• Gold / Commodities (ETFs, Gold Funds) - Acts as a hedge during inflation or market uncertainty.
• International Equities - Exposure to global markets helps reduce dependence on the domestic market. Adding international funds provides exposure to different economies, currencies, and corporate cycles, which can act as a powerful diversifier.

By mixing asset classes, you ensure that not all investments move in the same direction at the same time. Your final asset allocation should be a function of your financial needs and risk tolerance.

2. Diversification Across Categories within Equity

Even within equities, funds can be chosen to balance stability and growth:

• Large-Cap Funds - Invest in blue-chip companies; stable and less volatile.
• Mid-Cap & Small-Cap Funds - Higher growth potential but more volatile.
• Sector/Thematic Funds - Target specific themes (IT, Pharma, Banking); higher risk but can boost returns if timed right.
• Hybrid Funds - Mix of equity & debt for balanced growth.

3. Diversification Through Investment Styles

Investment styles represent different philosophies of Investing. Mixing styles brings balance to the portfolio:

• Growth Style - Focuses on companies with high earnings potential (e.g., tech firms).
• Value Style - Looks for undervalued companies trading below intrinsic worth.
• Blend / Core Style - A mix of growth and value, balancing stability with opportunities.

4. Diversification by Strategy

Mutual funds also differ in the strategy they follow to construct portfolios:

a) Active Funds: The Alpha-Seeker

• The Goal: Active funds aim to generate "alpha", or returns that outperform a market benchmark. This is achieved through a fund manager's research and stock-picking expertise.
• The Challenge: There is a risk that the fund manager might underperform the index. Many active funds, especially in the large-cap space, might end up with a high overlap with the benchmark, negating their "active" nature.

b) Passive Funds: The Beta-Capturer

• The Goal: Passive funds (Index Funds and ETFs) are designed to simply replicate the performance of a market index. The objective is to capture the market's "beta" (or market returns) at the lowest possible cost.
• The Challenge: A portfolio of only passive funds is still concentrated in the underlying index. If the Nifty 50 is heavily weighted in financial services, so will be your passive portfolio.

c) Factor-based/Rule-Based Funds

• The Goal: This approach sits between active and passive. These funds use algorithms and data models to eliminate human bias in selection.
• Rule-based funds add a new dimension of diversification based on factors rather than just market cap. For example:
  • Value Funds: Invest in companies deemed undervalued.
  • Momentum Funds: Invest in stocks with recent strong performance.
  • Quality Funds: Select companies based on strong fundamentals.

These funds can capture unique return streams and reduce correlation with traditional market-cap-weighted indices.

Principles of Building a Resilient Portfolio

Once you've chosen your funds based on the above layers, it's time to validate your strategy.

1. Avoid Duplication
   

   Holding too many funds often leads to owning the same stocks multiple times, reducing the benefit of diversification. Use portfolio overlap tools to ensure your schemes complement each other rather than mirror each other.

2. Limit the Number of Funds
   

   A small, focused portfolio is easier to track and manage. Beyond 6-7 funds, returns often get diluted, and monitoring performance becomes unnecessarily complicated.

3. Mix Asset Classes
   

   Spreading across asset classes ensures your portfolio doesn’t rely on just one market. While equity drives long-term growth, debt provides safety, and gold or international funds act as hedges during uncertainty.

4. Balance Styles & Strategies
   

   Combine different investing styles (growth + value) and strategies (active + passive/Factor-based). This reduces the risk of one approach underperforming for a long period.

5. Review Annually
   

   Portfolios must evolve with time. An annual review helps weed out duplication and realign investments with your financial needs and risk profile.

Final Word

True diversification is not about having "many funds", but about having the right mix. By spreading across asset classes, categories, styles, and strategies, investors can create a portfolio that is resilient, manageable, and need-based.

Because in investing, smart diversification protects wealth - blind diversification only complicates it.

Disclaimer: Mutual Fund investments are subject to market risks, read all the scheme related documents carefully.