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Diversification: the stamp of a good fund

You may often hear of diversification as the cornerstone of any sound investment strategy, but there’s always been a strong and vocal anti-diversification idea running through investing as well. Dhirendra Kumar writes.

india Updated: Jun 24, 2012 20:14 IST

You may often hear of diversification as the cornerstone of any sound investment strategy, but there’s always been a strong and vocal anti-diversification idea running through investing as well. Amongst Indian mutual funds too, there have always been funds that claim to be focused and have a certain upper limit on the diversification across stocks. Some people have always said that it’s better to narrow down your choices to a handful that you’re really sure of and then concentrate your investments.

The idea is that if you’ve identified a handful of real winners, why dilute their gains by spreading money around in also-rans? The most famous votary of this anti-diversification idea is supposed to be Warren Buffett. The legendary investor is supposed to have said, “Diversification is protection against ignorance.”

What that means basically, is that it’s a question of safety versus aggression. For mere mortals, diversification should eventually yield better returns by protecting an investor against bad choices. So what about the mutual funds that say that they are “focused”? To try and answer this question, I analysed the returns data for all non-sectoral and non-thematic equity funds for the last five years and correlated this with a simple measure of the degree of diversification in their portfolio. It turns out that on a broad basis, funds with higher diversification have better returns. For example, while looking at the last three years, top one-fourth of funds on the diversification scale had returns of 11% per annum while the bottom one fourth had returns of little more than 5% per annum.

Now, this is just a correlation and as an analyst, I’m notclaiming that I’ve shown proof of cause and effect. However, diversification is one of the things that investors are supposed look for in a fund and that’s very much the right idea.