Don't diversify beyond a point

Too much diversification harms your chances of beating the broad market indices convincingly

If you wish to outperform a broad market index, you need to follow a concentrated approach. Not only should the funds that you bet on put their money in a limited number of stocks, the number of funds you hold in your portfolio should also not be excessive. Diversify too much and you not only diversify away the risk in your portfolio but also the possibility of generating alpha. 

The allocation to each stock is linked to the total number of stocks in the portfolio. As the number of stocks rises, the probability of making sub-optimal allocations also rises. In a large portfolio, you could also have a very long tail of stocks to which allocation is so minuscule that they contribute nothing to the portfolio’s performance. 

Creeping diversification   

An average mutual fund has anywhere between 50 and 100 stocks in its portfolio. Barring a few exceptions, fund managers do not set out to create portfolios with so many stocks. But portfolios become that way over time due to a variety of reasons. The fund manager may have initiated a position but failed to build on it. He may have invested in a new issue but did not get adequate allotment. An idea may have turned out to be bad but the fund manager doesn’t wish to sell it at a loss (a phenomenon referred to as loss aversion). Sometimes, there may not be adequate liquidity in a stock. The fund manager may have initiated a position to test the waters and watch the stock’s results for a couple of quarters before buying more. At times, the fund manager is flush with funds and hence needs more ideas to deploy the money. Sometimes he has too many ideas and doesn’t want to shoot down any. In some cases, the fund manager buys more stocks so that he can have representation to all the sectors, and sometimes because he feels he can’t go away from the index or the broad market. At times, it could be because he picked a theme and then made top-down purchases of a mix of companies within it. 

Bane of excessive diversification  

Just as fund managers agonise over stocks, mutual fund investors and their wealth advisors spend time evaluating which schemes are doing well, which are not, and where to invest next. There is a lot of discussion on which funds to buy, but not enough on how much to buy.

The number of stocks, and allocation to each in a fund, impacts the fund’s performance. Similarly, the number of funds in an investor’s portfolio, and the percentage allocation to each, impacts the investor’s returns. Excessive diversification at the portfolio level compounds the diversification at the fund level. Diversification does indeed reduce risk, but it also reduces returns. If you maximise risk reduction, you will pretty much reduce the alpha to zero. 

Over the 18 years I have spent in the mutual fund industry, I have seen that on an average, a serious, experienced investor holds at least seven to 10 equity schemes of various types from multiple fund houses, driven chiefly by the imperative to diversify. Back of the envelope calculations tell me that with 40-60, and sometimes 70-100, stocks per equity fund portfolio, these well-diversified portfolios altogether hold 400-600 scrips. A number of stocks held by managers could be common across schemes, hence de-duplication would bring the number down to 250-300.

What return do you think such portfolios generate? To arrive at the answer, we performed a small experiment. We took the top 10 mutual fund schemes by asset under management (or AUM, using  AUM as a proxy for popularity and likelihood of ownership by investors) and created an equal-weighted portfolio. The total number of stocks an investor would be exposed to by investing in these funds stood at 598. On de-duplication, the number of unique stocks came down to 247. When the returns of this portfolio of funds was checked on April 30, 2017 for different time periods, we found that alpha had been pretty much diversified away along with risk (see table). What is noteworthy is that in none of the time frames was the alpha over the S&P BSE 200 in excess of 2 percentage points. It goes to show that if you own 250-odd stocks and compete with an index of 200 stocks, your chances of outperformance get marginalised. So much for engaging active fund managers to offer you well researched portfolios and for your own research on which funds to pick. 

Let me clarify: this is not a comment on the underlying funds or investors’ efforts at selecting funds. Each of these funds on its own may not have done badly, and the better ones may even have delivered superior alpha. But the error lay in spreading oneself too thin. On the other hand, by being a little more discerning one could have increased the probability of outperformance.

Profit by staying focused 

To beat the markets convincingly investors need to focus. Hence it is advisable to build a focused portfolio of focused, or at least not too widely diversified, funds. This is also helpful from the point of view of transparency of performance, ability to keep a check on performance attribution, and pure administrative convenience. 

Both for fund managers and investors, beating the market convincingly is the single most important outcome, otherwise there is always the option of buying the index. Owning seven-10 widely diversified equity funds is a very expensive way of trying to beat the market by owning pretty much most of it. With this kind of diversification investors will end up getting index plus or minus few percentage points at best.

Are focused funds better?

Next, let us turn to the question of whether focused funds are better than diversified funds. The answer is that one can have a diversified portfolio of 50 stocks all turning out to be winners (against the laws of probability), and one can have a highly focused portfolio of PSU banks and telecom companies (in the current market context) that performs poorly. This explains why some focused funds do not do well. Much depends on how well the fund is managed. 

When picking a focused fund, check whether it follows the following points. One, a focused strategy should be accompanied by index-agnostic, bottom-up and fundamental-research driven stock picking. Two, financial theory suggests that owning more than 20 stocks doesn’t result in further risk reduction, so focused portfolios should avoid having more than 15-20 ideas. Three, the universe from which the fund manager intends to pick stocks needs to be distilled and focused in the first place. Also, the fund manager needs to have a sense of the size of the fund that can be managed with focused portfolio allocations. If the fund manager of a focused fund doesn’t control these parameters and there is interplay among them, it will become difficult to remain focused or produce the right outcomes for investors. 

Finally, remember that if you buy the market, you cannot beat the market. 

The writer is managing director and CEO, Motilal Oswal Asset Management