Over-diversified mutual funds give good returns. Should you invest?

Nippon India Small Cap fund is nearing a double century. The figure does not represent its return, but the number of stocks in its portfolio. Yet, it is carrying its size with elan. Overly diversified funds are often viewed with suspicion, perceived as a drag on returns and lacking conviction. But is a bloated mutual fund portfolio necessarily a white elephant? Several equity funds nowadays appear comfortable running fat portfolios with long tails. There are nearly 20 schemes packed with 80 or more bets, compared to just four such schemes two years ago. Five of these are stuffed with over 100 stocks. Not surprisingly, most of these schemes belong to the small-cap category. Others have a sizeable presence in both mid caps and small caps. In the small-cap space, extensive diversification is a must due to liquidity constraints and a higher mortality rate among businesses. As the asset size rises, the funds resort to spreading their bets thin to maintain portfolio hygiene.

Kaustubh Belapurkar, Director, Fund Research, Morningstar Investment Adviser India, observes, “The opportunity in small caps has expanded. Besides, fund managers have to keep a finger on the pulse of the underlying liquidity profile.” For a Rs.10,000 crore small-cap fund, taking a 2% individual allocation means buying a Rs.200 crore block of shares of an Rs.8,000 crore market cap firm. This can get tricky, says Amol Joshi, Founder, PlanRupee Investment Services. Liquidating a position can be challenging too. Often, fund managers build positions gradually, testing the waters for the investing thesis to play out. This results in a long tail portfolio.

With 193 stocks, Nippon India Small Cap is the poster boy for extensive diversification. As assets expanded from Rs.16,612 crore in July 2021 to Rs.34,468 crore in July 2023, its portfolio bets nearly doubled. Its top 10 stocks account for a mere 15% of its corpus. Its biggest position forms less than 3% of its portfolio. Fund Manager Samir Rachh has no qualms about this approach and believes diversification is a virtue in small caps. One is better off diversifying heavily in small caps rather than showing conviction, he says. If ideas go wrong in this space,one can lose badly, Rachh insists.

Several funds are overly diversified
Spreading the bets thinly is often perceived as a drag on returns.

Image-1

This approach also allows him the strength to stay in the game when conditions are tricky. The general perception is that spreading bets thinly dilutes the returns. It doesn’t allow winners enough heft to influence fund returns. Far from getting bogged down, Nippon India Small Cap has put on a stellar performance despite its sharp weight gain. It is currently among the toppers in its category over the past one, three and five years. This is not a one-off outcome. Returns rolled since 2017 indicate that the fund has managed to outperform its category average 99.72% of the times over three-year time frames. Even as Rachh concedes a long tail can be dilutive, he maintains that the winners among top 20-25 bets compensate for it. Joshi asserts, “It says a lot about the research capabilities of the fund house that it has not let the need for diversifying dilute the fund returns.”
Even as the biggest small-cap fund has hungrily devoured stocks, the biggest mid-cap fund has avoided taking this path. HDFC Mid-Cap Opportunities, with assets of Rs.45,450 crore, up from Rs.30,524 crore two years ago, has shed individual positions from 68 to 63. Belapurkar observes, “It is simply a different style. Fund Manager Chirag Setalvad has traditionally run a compact portfolio, emphasising high conviction bets.” Interestingly, another fund from the HDFC MF stables, the Rs.10,679 crore HDFC Large & Mid Cap, has taken the opposite stance. It currently runs a portfolio of 162 stocks. Only two years ago, when it was a Rs.2,735 crore fund, it housed 66 stocks. This fund is managed by another veteran Fund Manager, Gopal Agrawal. Despite having lesser mid-cap exposure, HDFC Large & Mid Cap has opted for a deeper diversification than HDFC Mid-Cap Opportunities. The contrasting approach is reflective of HDFC MF’s recent stress on different fund management styles under one roof. While Agrawal’s style has a bias for momentum, Setalvad shows a preference for undervalued stocks. The two funds’ diversification stance varies accordingly. Both funds have put in a strong performance in their respective categories in recent years.
So, is it time to shed the aversion for fat funds and long tails? Globally, a strong historical precedent for adopting such a strategy is set by legendary investor Peter Lynch’s US-based Magellan Fund. It ran a 1,400-stock portfolio and clocked over 29% annualised return over its 13-year term. But not every crowded fund boasts a healthy record. Belapurkar asserts, “There is no right or wrong approach. Both styles can work. One has to understand the triggers and context of the fund’s strategy.” Joshi reckons investors need not fret over the extent of diversification. “The investors who take the mutual fund route cannot undertake stock selection or sector allocation on their own. The fund manager is best placed to decide how to construct the portfolio.”