What does diversification entail in context of mutual funds and how does it operate?

New Delhi: Investments and risk are closely linked. When an investor decides to invest, there is an inherent element of risking her capital, whether partially or entirely. Nevertheless, the objective or intention of investing is never to incur losses.

Hence, fund managers endeavor to mitigate risk by employing a strategy known as 'diversification'. Investing in stocks entails various risks, encompassing price fluctuations, market volatility, and even company-specific vulnerabilities.

Defining diversification

Diversification stands as a primary benefit of investing in mutual funds. Inherent to the concept of mutual funds, fund managers distribute scheme assets among various securities and debt instruments.

The practice of spreading investments across multiple financial instruments to reduce risk is known as diversification.

Mutual fund companies take measures to counterbalance potential losses from the decrease in prices of certain securities by leveraging potential price increases in other securities within the fund's portfolio.

Additionally, there exists another type of risk called liquidity risk. Thanks to regulatory provisions, mutual fund companies are obligated to facilitate the transfer of mutual fund proceeds to the seller's bank account within two days of the transaction (T+2).

Certain equity mutual fund schemes are inherently diversified. For example, a Nifty index fund allocates investments across 50 distinct stocks, while a Sensex 100 index fund diversifies investments among the top 100 stocks.

Likewise, flexi-cap mutual funds disperse their assets across various market capitalization segments (small cap, mid cap, and large cap), adhering to the principles of diversification in both theory and practice.

Determining the level of diversification in a mutual fund investment is straightforward. A visit to the specific scheme's webpage on the official website of the asset management company (AMC) provides this information.

Sectoral mutual funds

Mutual funds that adhere to specific themes such as value, contra, and dividend yield similarly allocate investments to a range of securities that correspond to these predefined themes.

Furthermore, these funds are required to allocate a minimum of 65 percent of their assets to equity and equity-related instruments.

They possess the freedom to determine the allocation of the remaining 35 percent of their portfolio, which can be invested across various asset classes like bonds and gold. As a result, the mutual fund scheme achieves comprehensive diversification in relation to its risk exposure.

Nevertheless, a handful of mutual fund categories exhibit a distinct concentration. For instance, sectoral funds are designed to allocate a significant portion of their assets to a specific industry sector like IT or FMCG.

These funds inherently carry an elevated risk profile. However, they do incorporate a certain level of diversification by investing their funds across multiple companies, albeit all within the same sector.