Portfolio Construct

How Many Mutual Funds Should You Have in Your Investment Portfolio?


This is a trick-question as how many and which type depends upon a host of factors such as my risk appetite, financial goals etc.

Time to take an inventory of your mutual funds. How many are there? What are their investment styles? Is your portfolio of mutual funds cluttered just like your closet? Have you owned some mutual funds so long that you have forgotten why you bought them? Are there some mutual funds on the top shelf, way in the back of your financial closet you haven't even looked at in a while?

Adding new mutual funds to your portfolio is far easier than reorganizing your fund portfolio and discarding inappropriate, redundant, or simply poor-performing mutual funds. The answer to the question of how many mutual funds you should have in your portfolio is not just a number. But if you have many more than eight mutual funds in your closet, chances are you need to do some serious portfolio cleaning; and here's why.

First, in order to be well-diversified, your mutual fund portfolio should be invested in stock mutual funds and in fixed-income mutual funds or income fund equivalents. Within the stock mutual funds, your mutual funds should cover large-cap stocks, small-cap stocks, and mid-cap stocks.

In case you are making investments across the shores, one should cover established firms in industrialized countries and stocks of countries that would be considered emerging markets. While geographic diversification domestically is relatively unimportant, diversification by region for foreign investments is. Representation in Europe for large stock international mutual funds is important, and investments in Latin America and the Pacific Rim are crucial when considering emerging stock mutual funds. Global mutual funds that invest domestically and abroad sound like a one-fund answer, but it is too much geography for one portfolio manager to cover and global funds tend to change domestic/foreign portfolio weights as world conditions change, neutralizing some diversification benefits.


Counting the Mutual Funds
Let's stop and take a count: one large-cap fund, one small-cap fund, one emerging sector fund—so far, three mutual funds. Have we missed the mid-cap stocks? Well, check your large-cap fund and your small-cap fund to see what they include. Usually, large-cap funds leak down into the mid-cap range and small-cap funds push up into the mid-cap range. If not, add a mid-cap mutual fund to avoid any portfolio gaps. Now we may be up to four, all of which are stock mutual funds at this point.

If you want income and the diversification benefit of a fixed-income fund, then a simple choice would be to consider Debt mutual funds with a decent focus towards Government Bonds. These funds on a 3 to 10 year weighted average maturity deliver stability in the portfolio and captures most of the yield of longer-term mutual funds when interest rates change. If you are in a high tax bracket, a stable tax-saving fund might be a better choice. Aggressive investors can reach to high-yield corporate bond funds and while these funds invest in lower-quality corporate debt that pays high income, the individual default risk of the bonds in the portfolio is softened through diversification and the high income dampens portfolio volatility. Furthermore, high-yield bonds tend to be sensitive to the economic cycle, acting more like stocks than government bonds.

So, if we add one to our fund count for a fixed-income fund we have a total of five mutual funds; and another in GILT securities fund would push the kitty to six.


Other Categories of Mutual Funds
What about all those other categories of mutual funds? Do you need a gold fund, sector fund, index fund?

Let's take them one at a time...

Gold mutual funds are concentrated sector funds holding gold mining stocks primarily in North America, South Africa, and Australia. They are extremely volatile, as gold price changes are magnified by the operating cost break-even points of gold mining firms. Do you need a gold fund in your portfolio? No. Most investors use gold funds as a store of value, a hedge against inflation. Over the last decade, however, they have been neither. When stocks are roaring up, you would like your gold fund to behave like a stock, but it tends to act like gold bullion. When the stock market collapses, you hope your gold fund behaves like gold bullion, but unfortunately, it tends to act more like a stock. Hence, I would then rather take a Gold Exchange Traded Fund which is Gold Bullion in that case and would actually provide the hedge the portfolio needs especially given the volatile times we are in.

Sector mutual funds concentrate on one industry or a few closely related industries. Because they are concentrated in an industry, they are not well diversified. Beyond the additional risk, the trick to master is just which sector funds to invest in. At the top of most "best-performing mutual funds" lists will be some sector funds, but they'll also appear on the "worst-performing mutual funds" lists—it's just a question of when. Most aggressively managed stock mutual funds concentrate in some industries and might be viewed as a combination of sector funds. Few investors are willing and able to place sector bets unless they have particular experience in a sector through their education, work experience or vocation, and if they do have expertise, selecting individual stocks may be more rewarding. So, unless there are strong convictions on a sector and one doesn't really have the time to pick up stocks

Do index mutual funds have a place in your portfolio? Yes, but they don't add to the number of funds. They simply are another way of managing your assets in one of the fund categories necessary for a rational, well-diversified, non-redundant mutual fund portfolio. Index mutual funds should be employed in a situation where even the brightest and best of portfolio managers using superior timing and stock selection decisions would have difficulty overcoming the cost advantage of an index fund. Areas of the markets that are efficient, have readily available information, are well-researched and followed closely by the investment community, or are simply not susceptible to very profitable analysis are candidates for indexing. These markets have attributes that make intelligent, thorough analysis more likely to contribute returns that can overcome the cost of active fund management.


Style Diversification in a Portfolio of Mutual Funds
An added classification for domestic funds is investment style—mutual funds can be categorized as growth or value, or both. Growth mutual funds would typically invest in stocks with high earnings growth expectations; value mutual funds would invest in stocks with low prices relative to earnings and net asset values. The style label should be based not on what the fund says it is or what it says it will do, but on what it does. Investment style classification should serve to help investors avoid redundancies and coverage gaps. But they also beg the question, "Should a portfolio of stock mutual funds be diversified by style as well as size of stocks?" Size, yes. Style, perhaps.

Many mutual funds operate in more than one stock size range and many use approaches that are classified as both growth and value. Do you need a value and growth fund in each stock size category? No. One value fund, and it might be the large-cap fund, and one growth fund covering the mid-sized and small stock area provide coverage of size and style. An index fund can be both growth and value, and more extensive indexes will cover value and growth for more stocks and stock size ranges.


Eight Is Enough…
Understanding the style and stock size characteristics of mutual funds will help prevent duplication and unnecessary run-up in the number of mutual funds in your portfolio. Now, back to our count of mutual funds: We left off at six with one fixed-income fund, or seven funds with a fixed-income fund and GILT fund. Add a money market fund and the counter clicks to eight. Be sure you can justify adding mutual funds to your portfolio beyond eight. Make certain you need them, that they truly cover new ground in asset type, geography, or investment style, and that the addition is meaningful.

Taking the time to create an organized, understandable, appropriate and efficient portfolio of mutual funds may be your most important investment.


But, What if one doesn't have time...
Off late, funds with hybrid asset allocation have become popular. These funds invest in different assets (debt & equity) on the basis of predefined asset allocation (moderate / low / aggressive). Also, there are funds with dynamic asset allocation on the basis of statistical models (quant models). Investing in these funds would enable you to have the same exposure to asset classes and reduce the number of overall investments. This is best suited for a person who doesn't take active calls between equity & debt.



The response is inspired by John Markese's response to a similar question put up to him in the AAII Journal, and adapted to the Indian context. John is the President of AAII, the American Association for Individual Investors. I also thank Rajnish Girdhar, Anamika Mattey and Manish Rangwani for their inputs.