Mutual Funds-Are you really diversifying your investments?

It is good suggestion what you will get from your planners to invest in mutual funds to reduce your risk, diversify your portfolio which will not be possible with direct equity investment. But have you ever looked the sector wise risk or stock wise risk your funds posing? Are you able to sustain such risk? Lot may have not looked underlying sector their funds are investing. So discuss how such things may drag your returns.

Let us say, you have investable surplus of around Rs.25,000 PM and want to invest in some well performing funds. What you will do?? You go through some fund rating sites and select few top rated funds or you consult your adviser to guide you in investing this surplus for your financial goals. Finally you will end up in selecting the funds like Large Cap, Large and Mid Cap, Multi Cap, Mid and Small Cap, Sector specific funds, Balanced Funds, Debt funds. Based on your waiting period and goal, you start to invest in such classified funds and think that you really diversified your investments.

But if you go through the portfolio of your mutual funds holding then you will notice that either sectors are overlapped or specific stocks are overlapped. Finally indirectly you will end up in higher exposure to specific sector or stocks. To give you the clear picture about what I said above, let us take the example of the few funds and their holdings. I will take one fund from each sector to verify (thinking that you selected five funds to invest Rs.5,000 in each fund). It is my choice of funds which I selected based on their performance under each sector.

1) Large Cap-Franklin India Bluechip Fund (G)

2) Large and Mid Cap-HDFC Top 200 Fund (G)

3) Multi Cap-HDFC Equity (G)

4) Mid & Small Cap-Reliance Equity Opportunities Fund (G)

5) Balanced Fund-HDFC Prudence Fund(G).

First let us see by investing Rs.5,000 in the above said each funds how much really you have sector wise diversification.

From the above table you come to know that around 20% of your investment is going towards Financial sector, energy around 10%, Healthcare around 7% and Technology 8.52%. Eventhough you opted the route of mutual fund and within which you opted the different types of funds to diversify your portfolio, still you end up in overlapping of your investment in some sectors. Suppose due to some bad news, financial stocks and energy stocks not performed well then your 1/3 of investment will be under performer.

If you look at the underlying stocks of each sector they have, again they will shows mostly same stocks. Reason for that is, mutual funds always invest in more liquid stocks to avoid the impact cost. This is the case with the investor who diversified his investment choosing different sectors.

What will happen if you started investment under same sector with two funds? Like two large cap funds or two large and mid cap funds, most probably your  major chunk of investment is overlapping which you will not notice. Once that major sector under perform,  your investments will show negative returns. Take for example, you have surplus of Rs.20,000 PM and you selected two funds to invest. But this time selection is from the same sector like two large cap funds or two large and mid cap funds. In such a situation let us see how much risk you have.

Fund selected for the above case are

1) Large Cap-DSPBR Top 100 Fund (G) and Franklin India Bluechip Fund (G)

2) HDFC Top 200 Fund (G) and Birla Sunlife Frontline Equity (G)

Portfolio diversification of each funds is as below.

1) For two large cap mutual fund investments.

2) For two large and mid cap mutual fund investments.

From above two tables you will notice that almost 50% of your investment will be in Financial sector and around 30% of your investment will be in Energy sector. So total around 80% of your investment will be within these two sectors. Now what will happen to your investments if these two sectors under perform?

Hence by just looking at investment in mutual fund as diversification or selecting few funds from the rating or past performance never judge that you really diversified. Look at each funds underlying portfolio, based on the risk they pose and your financial goals start to invest.

(Note-Mutual Funds holding as on 31st July 2012 and holding of funds selected considering the majority %, hence ignored the lower % of holdings)