Want to create a robust MF portfolio? Here's the way

The asset classes have their own cycles and hence the return potential. The best way to ensure risk reduction and return protection is to spread across the various asset classes. This is what is also known as diversification, often relates to the adage of not keeping all eggs in the same basket. Diversification is achieved by creating a portfolio of asset classes so that each participate at various times and thus also reduce the possibility of risk due to the market volatility.

While asset class diversification is at the core of the portfolio creation, there could be asset sub-classes that could refine the distribution within an asset class. So, diversification involves in thematic or sectoral distribution within an asset class or in case of equity it could capitalization based i.e., large, mid and small cap based. While diversification has its own benefits, too much of it can spoil the original intent. Moreover, one needs to guard against the perceived versus the actual diversification.

This could happen when investors create a portfolio of mutual funds. When opting for a category-based diversification, as defined by SEBI, one may end up with a solution that wasn't meant to be. The MF portfolio should be differential, non-correlated or at least less correlated and with varied risk profiles. Most often, we tend to go with the name of the category and fail to distinguish the difference within the portfolios.

At times, the portfolio consists of flexi-cap funds along with large-cap funds occupying higher proportion than the other categories. This could be because investors might have considered the past performance of a certain period and opted for funds out of these categories. And as the name suggests, flexi-cap funds have a flexible mandate in terms of investing in the category i.e., there's no specific proportion of allocation towards a particular category of stocks.

But historically, the proportionate exposure to large cap stocks in the flexi-cap funds has remained high and, in many cases, majority of the investment is concentrated there. It tends to be true especially when the markets exhibit higher volatility. While opting for flexi-cap funds, one must also look at the risk profile of these instruments. Of course, if the investor's risk appetite matches to that of the product's, then it's an ideal match. Well in that case, one is better off with either of large cap or flexi cap, instead of both in their portfolios.

If one is particular about diversification, with an increasing risk appetite then a multi-cap fund would do better than a flexi cap. The regulations in a multi-cap insist a minimum exposure to both mid and small cap irrespective of the market conditions. Of course, fund managers could have a larger portfolio overlap as they tend to look for investment areas that generate higher returns and so bet in certain sectors. Excepting for a sectoral or a thematic fund where the mandate is to stick to the theme or sector, the sectoral allocation might have an overlap across various categories of funds.

However, in a capitalization-based fund, the chances of stock overlaps are limited as the fund manager sticks to majority of the stocks within the capitalization. Another is the percentage of exposure to a particular stock, despite the sectoral preference, the funds would have differential allocation to a particular stock though that could be a minute portion, is to be considered.

So, overall, a mutual fund portfolio could avoid exposing to multiple funds from the same category purely because they have performed better or assuming to perform better in the future. This is particularly true with large cap category where the fund as per the regulation can't go past the top 100 stocks of the market. Avoiding these missteps helps investors create a robust portfolio.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at [email protected])