Mutual funds are a great instrument for retail investors to participate in equity markets. They offer professional management of investor's money and spread out costs of doing so over a large asset base. Last few years the Indian retail investor has taken an increasingly greater interest in the mutual fund route. This is a welcome trend as it gives retail investors a vehicle to invest in equities at risk lower than that of investing directly in stocks.

Now that investors are waking up to mutual funds, they should understand a few intricacies of making the best use of that vehicle. A common error most investors tend to make is holding too many funds. This as we explain below is a wasteful exercise.

Mis-treatment of mutual funds as equity stocks

Many investors tend to treat mutual fund schemes as equity stocks. They feel that just as holding 2-3 stocks is inherently risky, so is holding 2-3 mutual funds. When they try to apply the traditional wisdom of diversification to their mutual fund portfolio, they naturally think about spreading their investments over a large number of funds - say 15-20.

A mutual fund itself invests in a large number of stocks. More focused funds (e.g. sector funds) invest in anywhere between 20 and 50 stocks while the diversified funds often invest in as many as 80-120 stocks. Each fund also has its own way to stock selection.

Thus often 10-15 mutual fund schemes, especially diversified ones, among them will cover a lot of different stocks. This in effect amounts to holding the market portfolio itself. We show an illustration of the same below.

The issue with holding stock market portfolio is that the mutual fund route is a costly method to do so. Equity mutual funds charge an entry load (and occasionally exit load) which goes to pay the distribution channel they use e.g. mutual fund broker, online investment sites. Mutual funds also charge the investors regularly for the expenses of running the fund as also professional advisory fees for their expertise. This is summarized into the expense ratio of a scheme which tells the investor how much it cost her this year to use the services of the asset management company.

This expense ratio is a per cent of the asset under management and is taken out of the net asset value of the scheme. If the expense ratio is 2 per cent, it means the asset management company has taken 2 per cent of the NAV of the scheme towards its fees and fund management expenses. The expense ratios vary between 1.5 and 2.5 per cent for equity mutual funds and are charged annually.

Self-defeating logic of excessive mutual fund diversification

Consider a mutual fund portfolio of 15 schemes. If our assertion is correct, this will provide returns in line with the overall stock market but will not beat it significantly. Over and above that, you will pay two per cent every year towards fund management.

A large proportion of this - i.e. the advisory fees - is in principle taken by the fund manager to beat the market. Hence if you have managed to stay only in line with the market and not beat it, the twp per cent you paid to various fund managers was an unnecessary expense. You could have simply invested in stock market index instead. That would have cost you less than one per cent per year and would have been much easier to manage as well.

You can invest in the broad market index in two ways. One is to invest in index fund schemes offered by various mutual funds. Second is to invest in Exchange Traded Index Funds. The second however requires a demat and trading account.

In either of these approaches, you are essentially investing in the market as a whole rather than specific stocks, sectors or themes. This model of investing is called passive investing and is a preferred mode of investing by many retail investors in developed markets.

The difficult way out!

However, this still does not mean that the mutual funds are redundant or retail investors should reconsider investing in active mutual funds. What is crucial to understand is that investors should not invest in too many actively managed mutual funds since that negates the very purpose of active investing.

The true purpose of active investing is to attempt beating the market returns. The fund manager charges the investor to do so. The investor in turn should ensure she gets the bang for the buck by restricting her fund selection to 5-7 schemes.

The biggest question is which schemes. Often an investor who is not sure about the answer to this question ends up reducing the risks by "diversifying" into 15-20 schemes. The methodology to select best mutual funds cannot be covered in this article since it requires a much detailed treatment.

Also, there are investor specific considerations which drive the selection. We recommend that the investor should either employ a financial advisor or do his own research to select appropriate schemes. If neither is acceptable or possible, the investor is much better off investing in index funds instead.

The author is director, PARK Financial Advisors, Mumbai. He is an MBA, Indian Institute of Management, Ahmedabad.