How can investors diversify their portfolios using mutual funds?

Investors are increasingly using mutual funds to build and diversify portfolios as they offer ease of investment, liquidity and transparency.

What is portfolio diversification and why is it important?
Different asset classes move in different directions, making it difficult to predict for investors. At times equity may rise, while gold may fall and vice versa. Hence, financial planners suggest the need to diversify portfolios. This essentially means investing in different securities and types of assets so that the overall return on your investment portfolio is not too dependent on any single security or asset. A diversified portfolio reduces risk without sacrificing much by way of returns. Many financial planners believe investors can earn a higher long-term return by holding a diversified portfolio.

How can investors diversify their portfolios using mutual funds?
Mutual funds in India offer a vast variety of schemes across asset classes which an investor can use to diversify the portfolio. For example, an investor looking to have 60% equity, 30% fixed income and 10% in gold can choose schemes accordingly. Among equities, investors can choose from largecap, mid-cap, small-cap, multi-cap or thematic funds to build the portfolio. In fixed income, they can choose from a mix of liquid, ultrashort-term, government securities or long-tenure bonds to build portfolios. In gold, they can use a gold ETF or a gold fund to allocate to the yellow metal. Investors can also use hybrid funds that combine various asset classes like equity, debt and gold in different percentages, helping maintain asset allocation.

What are the advantages?
There are many advantages of using mutual funds for diversification of portfolios. Mutual funds can be bought for small amounts of Rs 5,000 and in multiples of Rs 1 thereafter. Investors can make lump sum investments or decide to stagger using a systematic investment plan (SIP) with a minimum of Rs 500. They offer easy liquidity and in case you need the money back you can get it in three working days. The net asset value (NAV) of a scheme is declared daily and the portfolio holding is declared at the end of every month.

What are the risks of using MFs to diversify?
Investors should carefully choose products in line with their asset allocation and understand the risks involved while using any mutual fund scheme and the appropriate time frame they need to stay invested. For example, sectoral or thematic funds could carry far higher risk than diversified funds and there could be long periods when investors make no returns. Similarly, having an equity portfolio of only mid-cap and small-cap funds could carry high risk and high volatility. If interest rates start rising, there could be mark-to-market losses in long-tenure gilt funds.