In the investing world, usually there is a lot of research done on which companies to buy but not enough on how to allocate once you like a company.
Taking cues from the above statement, it is also relevant to the mutual fund investors as they do ample research through their wealth managers or distributors on which fund to invest in. However, it is not the only thing that one should emphasize on. More importantly, it is essential which fund needs to be allocated what portion of one’s investments. As it is empirical from the table above, total returns generated on the investments is an outcome of the how well the allocation is made.
It is observed that an investor of mutual funds typically has investments in 8-10 different schemes from various fund houses in the country. On further analysis, it has been found out that average number of stock in a diversified mutual fund portfolio is in the range of 55-70. Assuming that you have invested in 10 MF schemes which are top schemes by size, then your investments are typically exposed to about 600 stocks. On de-duplication, the number of stocks comes down to 250-300. Now, that your investments are exposed to such high number stocks, how do you feel you would be able to create wealth?
Mr. Warren Buffet states “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” The problem with diversification is that even though risk is mitigated to some extent by sector gains offsetting sector losses, the opposite is also true – sector losses offset sector gains and thus eventually reduce the returns.
As solution to the investors who do not like to diversify or over-diversify their investments, is focused style of investing. In the mutual funds space, there are schemes available which are built with not more than 20-25 stocks. These portfolios are high conviction as the investments are more concentrated. Does this means that the risk attached to such focused portfolios is higher? Not really, there are numerous studies that state that diversification of portfolio upto 20-25 stock reduces the risk substantially. Post this, for every next stock that is added to the portfolio, the risk reduction is marginal which may not add lead to any substantial change in risk.
On an analysis of top 10 mutual fund schemes by size we could conclude that the total number of stocks an investor is exposed to by investing in these funds is 598. Simply we can say that the average stocks in 10 schemes are 60. On de-duplication, the precise numbers of unique stocks are 247. Applying Pareto’s analysis of 80:20 it can broadly be concluded that 80% of the stocks would contribute to only 20% of the returns generated from these 10 schemes put together.
Now some analysis on performance. If you see the heat map of alpha you will be surprised to note the returns. The biggest funds by size picked as of April 2017 are the only ones showing slightly more alpha and that too over three years plus holding periods. Everything else is in the vicinity of 1-2% and lower. There is nothing wrong with the whole pattern, except that by being a little more discerning and choosy we can increase the outperformance. In the US, it’s not without similar reasons that ETFs are gaining popularity.
It is worth noting that in none of the time frames, the alpha over S&P BSE 200 is over 2%. It just goes to prove the point that if you own 250 odd stocks and compete with an index of 200 stocks, the chances of outperformance is marginalized. In order to beat the market, one has to adopt focused style of investing.