Different ways for diversification

If diversification is what you truly want, then follow it in spirit and not just in letter.

When financial planners and advisers suggest that the investor should practice diversification in one’s portfolio, what does it mean? The term “diversification" can have several connotations. Some investors like a concentrated portfolio; that’s a perfectly normal strategy that works for the risky appetite and in certain market conditions. But if diversification is what you truly want, then follow it in spirit and not just in letter.

Diversification of scrips

The simplest form to practice diversification is by investing in a diversified equity fund. These are funds that do not show any bias towards any particular sector. These funds invest across sectors and scrips. Some diversified funds, especially the smaller ones, prefer to hold about 20-30 scrips. As the size grows, usually fund managers find comfort in holding about 40 scrips or even more. But the number of scrips doesn’t usually matter, so long as your fund manager doesn’t invest more than, say, 8-9% in a single scrip.

Diversification within a sector

But diversification isn’t really limited to just sectoral diversification. Even a sectoral fund diversifies across many scrips. For instance, Reliance Banking Fund (RBF) has 18 scrips in it, as per its August 2012-end portfolio and Reliance Pharma Fund (RPF) has 20 scrips. These may sound like adequate diversification, but RBF has 39% in just the top three scrips. RPF fares a little better with 24% in the top two scrips. The problem that most sector funds face is lack of adequate and good quality scrips to invest in within the sector the fund aims to invest in. Typically, sectoral funds are concentrated in its top holdings; the bottom holdings are more diversified. Sectoral funds are the riskiest schemes as their fortunes get tied with just one or very few sectors. It doesn’t matter, then, that your sectoral fund diversified across 10 scrips or 30 scrips. When the sector goes down, most of the scrips in that sector goes down too.

Diversification across fund houses

By investing across many MF schemes and sticking to diversified equity funds, you may think that you are diversifying. But don’t forget to diversify across fund houses. You may have invested across many schemes and think you have a variety in your portfolio, but if you stick to only one or two funds houses, your fortunes get tied up with only them. What happens if the fund manager leaves the fund house or if the fund house gets sold to another fund house? Much of your portfolio will then be in doldrums. Getting rid of many schemes (within that one or two fund houses) can be a pain and you will then scout for new avenues for a significant portion of your portfolio.

Remember to practice diversification with as many angles as possible.