BackPortfolios: do number of stocks matter?
The number of stocks in a mutual fund scheme depend on many factors. Investors need to look beyond how diversified the fund portfolio is
Premium
Ever noticed how many stocks you are buying while investing in a mutual fund scheme? Data from Value Research Online shows that large-cap funds, on an average, hold around 38 shares, mid-cap funds around 50 and 52 for balanced funds (65-70% of their assets in equity). Stocks in a portfolio represent its diversification; it means spreading across more than one unit. For mutual fund portfolios the larger the number of securities, stocks or bonds, the more diversified it is said to be.
According to Harry Markowitz’s Modern Portfolio Theory, investors get the benefit of better performance from diversifying their portfolios as it reduces the risk of relying on only one security to generate returns. But who decides how many securities are needed to maximise return with adequate risk? While some studies have shown 20-30 stocks are optimum, putting an exact number will depend on many factors.
Strategy differs as per fund
According to empirical research done by Acuitas Capital, a Mumbai-based multi-family office, many domestic equity mutual funds would have delivered higher absolute returns, by keeping to their top stock ideas, as measured by conviction (active share). The research started out with 51 funds (diversified and open-ended) all of whom had outperformed their respective benchmarks over multiple rolling three year periods. Multiple filters decided the universe, such as the current manager having managed the fund over at least one market cycle. Seven multi-cap and four mid-cap funds made it to the final analysis.
For these, portfolios consisting of the fund managers’ top 10/15/20/25 stocks (rebalanced every six months) were constructed and compared with the original fund performance over a period of five-and-a-half years and four years, respectively. Conclusion: portfolio concentration improved performance.
“We found research that suggested that the optimum number of shares in a portfolio in US markets is between 20-30 (bit.ly/2f7RTO6). Not being able to find similar research for Indian markets, we first spoke to a number of fund managers in whose funds we are invested but were not satisfied with the responses. Results from our research were conclusive; fund managers would have done far better sticking to their top 20 ideas,"said Dinesh Vaswani, founder and managing director, Acuitas Capital Advisors.
Concentration below 20 stocks led returns from some funds to dip and the most consistent performance improvement, they found, was in 20 stock portfolios. However, putting an exact number is easier said than done. The final portfolio construction also depends on fund managers’ strategy, the specific market geography and market cycle at the time. According to S. Naren, executive director and chief information officer, ICICI Prudential Asset Management Co. Ltd, “Concentrated portfolios have the potential to deliver higher performance but with a higher risk or volatility. Concentration can vary with market cycles and change in size of the fund. When we look at portfolios, we do so in context of the product positioning or mandate and aligning investor objectives".
Concentration brings in risk
Be mindful that with fewer stocks come higher risks. According to Vikas Gupta, executive vice-president—traded markets and investment research, ArthVeda Fund Management Pvt. Ltd, “Analysis done globally shows as you keep reducing stocks in a portfolio, the variance (difference in return) compared to a market benchmark increases. Portfolio variance is found to be reasonable without compromising absolute return when there are between 25-50 stocks."
If concentrated portfolios do well the outperformance can be a big margin, but there is also the danger that individual stocks fail to perform as expected and then the high level of exposure in concentrated portfolios can result in underperformance by a large margin.
Amongst equity diversified schemes—out of 162 actively managed funds, only 17% have portfolios with less than 30 stocks. Some top performers have as many as 70-75 stocks at a time. Concentrated portfolios are seen to be more accessible through portfolio management services (PMS) meant for high net worth investors.
There is a higher degree of customisation and investors directly interact with fund managers around investment strategy. Given the minimum investment requirement of ₹ 25 lakh and lower public disclosure standards for PMS, for retail investors, mutual funds remain the most accessible way to invest in equity. The average outperformance of large cap diversified funds against the Sensex and Nifty for rolling returns over the last 5 years is around 2.5-3% annualised.
Atul Singh, managing director and chief executive officer—India, Julius Baer, said: “We don’t consider the number of stocks while recommending MF schemes. In case of direct equity portfolios for clients we have found that around 18-20 stocks work which is what our model portfolios have." Vaswani said often fund manager behaviour may be driven by investor behaviour. Given that often fund performance gets evaluated over a relatively short period, fund managers may not wish to risk potential higher short term volatility. Managers may not be optimising their potential return, but you need to look for schemes which consistently outperform the benchmark regardless of the number of stocks.
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!
