One flexi-cap, one mid-cap, one small-cap fund. Is your portfolio really diversified? Experts explain

Investors often assume that spreading their money across different mutual fund categories automatically creates a diversified portfolio. A combination of one flexi-cap, one mid-cap and one small-cap fund may appear to offer exposure across companies of different sizes. However, experts say the number and labels of funds are less important than what the schemes actually hold.

A flexi-cap fund itself can invest across large-, mid- and small-cap stocks. Therefore, adding separate mid-cap and small-cap funds may increase exposure to those segments without necessarily providing an equivalent increase in diversification.

“Three funds can be enough, but simply combining three categories does not guarantee diversification,” said Unmesh Kulkarni, Managing Director and Group Product Head. He said investors should look beyond fund labels and examine stock overlap, sector concentration, market-cap exposure and investment style.

For instance, two funds belonging to different categories could still own several of the same companies or have similar sector and factor exposures. In such a situation, an investor may own three schemes but remain exposed to similar risks.

Uttam Agarwal, Chief Business Officer at Bajaj Capital, also said three funds can provide a good starting framework, but the number of funds alone does not determine diversification.

“Two or three funds can still have significant overlap in stocks, sectors or investment themes, which may create an illusion of diversification,” Agarwal said.

Investors sometimes add schemes from different asset management companies believing that spreading investments across fund houses will reduce risk. Experts caution against using the number of AMCs or schemes as a proxy for diversification.

Kulkarni said investors should prioritise diversification of the underlying portfolio, followed by investment style and fund-management approach. Diversifying across fund houses can be useful, but it should not be considered diversification in itself.

“Three funds from three different AMCs does not necessarily reduce risk if all three have similar holdings,” he said. Conversely, two funds from the same AMC could provide meaningful diversification if their mandates, portfolios and investment styles are genuinely different.

Agarwal similarly recommended looking first at the underlying portfolio. Investors can then consider differences in investment styles and fund managers as additional layers of diversification.

The practical test is whether the funds provide different sources of risk and behave differently across market cycles, rather than simply carrying different names.

Investors should therefore check the top holdings, sector exposure, market-cap allocation and concentration of each fund before deciding whether another scheme is actually necessary.

There is no universal allocation that suits every investor.