Do funds with a lower number of stocks perform better?

‘Less is more’ or ‘the more the merrier’? This dilemma often troubles investors when selecting a mutual fund scheme. While some believe a fund with a high number of stocks is a better option, others feel a fund with fewer stocks can deliver better performance. What is the truth, and does the number of stocks really impact a fund’s return? Let’s find out more.

Understanding a mutual fund’s composition

The portfolio composition of a mutual fund tells you about the different types of investments the fund invests in. It gives you a breakdown of the types of assets, such as stocks, bonds, or cash that make up the fund.

When you look at a mutual fund’s portfolio composition, you can check the number of stocks it invests in. For example, an equity mutual fund will likely have more stocks than a debt fund. They might include a mix of stocks from different industries, such as finance, artificial intelligence, technology, real estate, etc. On the other hand, bond mutual funds may include more debt securities, including corporate and government bonds, than stocks.

Additionally, the fund’s composition also tells you about the type of companies the fund invests in. For example, small-cap mutual funds will have stocks from small-cap companies, whereas mid-cap mutual funds will have stocks from mid-cap companies.

What are the advantages of fewer stocks?

Here are some of the key advantages of funds holding fewer stocks:

• Better potential: The more stocks you add to a portfolio, the harder it becomes for the fund to generate strong returns. Over-diversification can impact the portfolio’s overall performance. In most cases, while some stocks perform well, they are not able to compensate for the lack of many others that fail to deliver. On the other hand, in the case of funds with fewer stocks, fund managers handpick the best options. They focus on promising companies, which increases the potential for growth.  
• Lower costs: Another benefit of having fewer stocks in a mutual fund is lower associated costs. Every time a fund buys or sells a stock, there are transaction costs involved. These costs are passed on to the investors and can eat into the returns. With fewer stocks in the portfolio, there are naturally fewer transactions, which results in a reduction in the overall costs. This can help improve the overall returns of the fund over time.
• Easier for investors to monitor: Although mutual fund investments are managed by professionals, it is always a good idea for investors to keep track of their holdings. When a fund holds fewer stocks, it becomes much easier to monitor what’s going on. You can stay updated on the performance of the fund’s key holdings and ensure they align with your financial goals. You will have fewer companies to research and track, which simplifies your task.

What are the disadvantages of fewer stocks?

While fewer stocks can offer many benefits, they also come with higher risks. Here are some of the main disadvantages:

• Less diversification: With fewer stocks, you naturally have less diversification, which means your exposure to risk increases. Even if a few of the companies in the fund underperform, it can significantly impact the overall returns of the mutual fund. By contrast, in a more diversified fund, the poor performance of a few stocks may not affect the overall performance of the fund.
• Greater dependence on the fund manager: In a fund with fewer stocks, the role of the fund manager becomes even more critical. Their ability to pick the right stocks and manage the portfolio effectively can have a more pronounced impact on the fund’s success. If the manager makes poor decisions or chooses underperforming stocks, it can be harder for the fund to deliver. In a diversified fund, the impact of a few bad picks might not be as detrimental.

Factors influencing a mutual fund’s performance other than the number of stocks

While the number of stocks in a mutual fund is an important consideration, it should never be the only factor. It is important to adopt a holistic approach, which includes considering the following factors:

1. The types of stocks: The specific types of stocks held in the fund can have a significant impact on the fund’s risk profile and potential for returns. Large-cap, mid-cap, and small-cap stocks all perform differently and have varying risk profiles. Similarly, growth and value stocks may also showcase different yield potentials.
2. The fund manager’s expertise: The fund manager’s performance plays a crucial role in a fund’s performance. It is essential to evaluate the fund manager’s track record and experience in managing similar funds.
3. Risk alignment with your goals: Always consider the risk involved in the mutual fund and how it aligns with your investment goals. Equity, debt, and hybrid funds pose different levels of risk and are suitable for varying needs.

Conclusion        

While you may consider the number of stocks in a fund before you make an investment through an SIP (Systematic Investment Plan) or otherwise, it should not be the only thing you see. You must also keep in mind the factors mentioned above to ensure you make a well-informed decision.

An investor education initiative by Edelweiss Mutual Fund

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