How to Avoid Overdiversification in Mutual Funds?

You might believe that the more mutual funds you own, the lower your risk will be. However, spreading your investments too thinly across many schemes may reduce risk only marginally, while complicating portfolio management and eroding potential returns. This is called overdiversification.

It occurs when you own multiple mutual funds that, despite appearing different, have similar holdings, styles, or categories, so their performance moves together. If you are someone aiming to build wealth steadily over the years, avoiding this trap is important, and that is what we are going to cover today.

How to Avoid Overdiversification in Mutual Fund Investing?

Here is how you can avoid overdiversification:

Define Goals

Before you compare mutual fund schemes, it is important to clarify your financial goal(s). Whether you are investing for retirement, education, or wealth creation, establishing your objectives allows you to select funds that are aligned with your investment timeline and risk tolerance levels.

Without an objective, you may find yourself investing in several funds for no real purpose and potentially becoming overdiversified.

Assess Correlation

You might find two schemes with different names, but they both track the same sectors or companies, resulting in overlapping holdings.

To check the correlation between mutual funds, use online portfolio analysis tools such as a mutual fund screener. You can find them on different investment platforms. These tools compare the historical returns of two or more funds to assess how closely they move in tandem.

A correlation value ranges from -1 to +1. If the value is near +1, it means both funds move similarly, and the scope of diversification is limited. If the value is near 0, it shows a weak relation, while -1 means they move in opposite directions.

For example, if you compare a large-cap equity fund with a short-term debt fund and find a correlation of 0.1, it means their movements are independent.

Limit Categories

It is important to avoid spreading your investments across too many mutual fund categories. Many investors assume that adding more fund types reduces risk, but in reality, most equity or hybrid funds already offer diversification between sectors and instruments.

Instead of keeping ten different funds, compare mutual funds and choose limited ones that match your risk tolerance and goals, such as one large-cap, one mid-cap, and one debt fund.

Review Holdings

It is important to check the mutual fund portfolio holdings periodically to avoid overlap. Different asset management companies may hold the same stocks that performed well. The overlapping holdings increase the risk of concentration, reducing the diversification of your portfolio.

Look at the fund fact sheets or portfolio disclosure documents to see where the funds are actually being invested. If you see duplication of holdings, consider decreasing underperforming fund exposure to eliminate redundancy.

Use the Core-Satellite Approach

Core-satellite couples stability with growth. In this, you create a ‘core’ portfolio of stable, long-term funds such as index or large-cap funds that offer consistent returns. Around this, you add a ‘satellite’ portion made up of high-risk, high-return funds like sectoral, thematic, or mid-cap funds to capture market opportunities.

For example, you may consider investing 70% in the Nifty 50 index and large-cap funds for steady growth and 30% in a technology or infrastructure fund for gains.

Focus on Quality

Instead of collecting numerous average-performing funds, concentrate on a few high-quality ones with a consistent track record.

Research the fund manager’s experience, historical returns, and risk management practices before adding a new fund option. This disciplined research process will help you avoid unnecessary diversification of the portfolio.

Factor in Costs

When selecting mutual funds or upcoming NFOs, always consider both costs and taxes before adding new schemes to your portfolio. Every fund carries an expense ratio, which is the annual fee a mutual fund charges its investors to manage and operate the fund, expressed as a percentage of assets under management. Holding too many funds increases your overall costs without necessarily improving returns.

Also, different funds attract varied capital gains taxes based on their holding period and asset type. If you have equity funds, short-term capital gains (STCG) are applied on units sold within 12 months from the date of acquisition; a 20% tax is levied on them.

Long-term capital gains (LTCG) on units held for over 12 months exceeding ₹1.25 lakh per financial year are taxed at 12.5% without indexation.

For debt funds, any investment made before April 1, 2023, will attract STCG if held for less than 36 months and is added to your income and taxed as per your income slab, whereas LTCG on units held for more than 36 months is taxed at 20% with indexation benefits. Post April 1, 2023, regardless of the holding period, STCG is applied. You should check the tax implications of switching or redeeming units frequently, as it may reduce net gains.

Mutual Funds Allocation Based on Risk Appetite

Here’s a simplified illustration of a diversified yet focused mutual fund portfolio for different types of investors with a 10-year horizon:

Conclusion

Overdiversification can dilute returns. They can also limit your portfolio’s effectiveness. To keep your mutual fund investments focused and goal-oriented, pick quality funds and avoid overlapping holdings.

You must also regularly monitor performance and, if required, go for a periodic rebalancing to ensure your portfolio suits your financial objectives and risk tolerance, helping you maximise growth while maintaining a manageable, well-structured investment strategy.

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