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Diversification in investment portfolios is a balancing act. While it aims to maximise returns with minimal risk, excessive diversification can lead to the opposite effect. Having many different assets under one asset class is certainly not diversification and more certainly not asset allocation.
Diversification isn’t just about accumulating various assets; it’s about intelligent asset allocation. Over-diversification often manifests in two critical flaws: disproportionate risk for returns comparable to benchmarks, and inflated fees and monitoring costs.
Compromising on discipline to rebalance portfolio
Sometimes the inclination of investment is towards an asset class that has outperformed. In such a case there is compromise on rebalancing, and the allocation towards an asset class could stretch out of sync with one’s investment objective and risk appetite. One can temper this with tactical calls, such as capping an allocation at 15% of the portfolio based on investor risk appetite and objectives. This way you can keep rebalancing the remaining portfolio to stay within your asset allocation. Effectively tactical allocation becomes an asset class in itself with a dynamic allocation. The buffer funds can be used toward these tactical calls.
Diversification and overlapping
In the name of diversification, simply adding more funds of the “me too” nature doesn’t help. This is more evident in the large cap space where the universe is small. Here the large cap funds appear to be hugging the index. Also, managing such an over-diversified portfolio can be more expensive due to transaction costs, management fees, and other associated expenses. This can erode overall returns, especially if the portfolio is spread across numerous funds with varying expense ratios.
In order to outperform an index through a large cap, an investor can opt for an active large cap fund with relatively large AUM, as it generally comes with a lower expense ratio.
The number of holdings in the MF space can also impact the diversification benefits. A large number of funds in the large cap space is bound to have significant overlap as the universe of large cap is relatively very small. While in the case of mid and small cap categories, it tends to have lower overlaps.
Funds deficiency in active share
Active share measures the level of differentiation between a mutual funds’ portfolio and its benchmark index. In case of deficiency in level of active share, the funds appear to be mimicking the index that it is supposed to outperform. In such a scenario, the active fund is more or less like the passive index fund with a high expense ratio. Unnecessary diversification could be on account of limited active share as it prohibits greater divergence from the benchmark. So irrespective of the number of funds one is invested in, the absence of significant active share would mean all funds mimicking or hugging the same index, thus adding no value through active management.
Moreover, absence of active share also implies absence of investment conviction to deviate from the benchmark index, thus compromising on an important objective of diversification to show outperformance.
Correlations in the market space
At times certain events in the market carry the strength to bring down the diversification benefits. In such a case the investment in assets and securities tend to show correlations and move in sync with each other and hence could be detrimental to the portfolio’s health. Assets classes like gold could be a good diversifier for the portfolio at such times.
The risk of unnecessary diversification is more evident if the fund’s performance, investment philosophy, expense ratio and long-term consistency is not taken duly into consideration. Ultimately, an informed assessment of active Share and other relevant metrics highlighted above can help investors make well-informed decisions and align their investment strategies with their goals and risk tolerance, thus helping their portfolio diversify in a true way.
(The writers is Director and Founder, Valtrust)