How to Use Mutual funds and ETFs for Instant Portfolio Diversification
How to Use Mutual funds and ETFs for Instant Portfolio Diversification
The foundational principle of intelligent investing is portfolio diversification—the strategy of not putting all your eggs in one basket. For Indian investors, this means spreading investments across various assets to mitigate risk and reduce volatility. However, building a truly diversified portfolio by purchasing dozens of individual stocks and bonds can be a complex, costly, and time-consuming endeavor.
Fortunately, modern financial instruments provide an elegant solution. Mutual funds and Exchange-Traded Funds (ETFs) are powerful tools that allow investors to achieve broad diversification instantly and cost-effectively. This guide will explore how to leverage these vehicles to build a resilient and well-balanced portfolio.
The Primary Benefits of Investing in Diversified Mutual Funds
The core advantage of using funds is the immediate diversification they offer. When you invest in a single unit of a diversified fund, you are essentially purchasing a small slice of a large, pre-built portfolio of securities.
Think of it like buying a pre-packaged fruit basket instead of visiting multiple vendors to buy each fruit individually. With one transaction, you get exposure to a variety of underlying assets selected and managed by professionals. This approach provides several key benefits:
- Instant Risk Spreading: Your investment is spread across numerous companies and sometimes even different asset classes, reducing the impact if any single security performs poorly.
- Professional Management: Actively managed funds are overseen by experienced fund managers who conduct research and make investment decisions on your behalf.
- Cost Efficiency: Buying a large number of individual stocks would incur significant brokerage fees. Funds benefit from economies of scale, making it a more cost-effective method for diversification.
Mutual Funds vs. ETFs for Portfolio Diversification
While both vehicles offer diversification, they operate differently. Choosing between them depends on your investment style and preferences.
| Feature | Mutual Funds | Exchange-Traded Funds (ETFs) |
| Management | Can be actively managed (fund manager makes buy/sell decisions) or passively managed (tracks an index). | Typically passively managed, designed to mirror a specific index (e.g., Nifty 50, Sensex). |
| Trading | Bought and sold through Asset Management Companies (AMCs) or distributors. Transactions are executed once per day at the fund’s end-of-day NAV. | Traded on stock exchanges like individual stocks throughout the day at their market price. A demat account is required. |
| Cost | Actively managed funds have higher expense ratios due to research and management costs. | Generally have lower expense ratios due to their passive management style. |
| Flexibility | Offer Systematic Investment Plans (SIPs) easily. | SIPs are possible but are facilitated through a stockbroker’s platform. |
For investors seeking a hands-off approach with expert management, an actively managed diversified mutual fund might be suitable. For those who prefer lower costs and the ability to trade intraday, ETFs are an excellent choice.
How to Build a Diversified Portfolio with ETFs
Building a portfolio with ETFs is a straightforward process that allows for precise control over your asset allocation. Here’s a simple framework:
- Establish Your Core: Start with a broad-market ETF that tracks a major Indian index like the Nifty 50 or Sensex. This gives you immediate exposure to the country’s largest and most established companies.
- Add Mid and Small-Cap Exposure: To capture growth from smaller, dynamic companies, you can add ETFs that track indices like the Nifty Midcap 150 or the Nifty Smallcap 250.
- Diversify Across Asset Classes: True diversification involves more than just equities. Consider adding a Gold ETF to your portfolio for commodity exposure, which often performs well when equities do not. Similarly, Debt ETFs that track government bond indices can provide stability and regular income.
- Go Global: To protect against domestic market risk, add an international ETF that tracks a global index like the S&P 500 or Nasdaq 100. This gives you a stake in the world’s largest companies.
Understanding the Price: How NAV is Calculated for a Fund
For mutual funds, the price of a single unit is known as its Net Asset Value (NAV). It represents the market value of the securities held by the scheme. The formula is:
NAV=Total Number of Fund Units Outstanding(Market Value of all Fund Assets−All Fund Liabilities)
In simpler terms, the fund’s assets (stocks, bonds) are valued at their current market price, all expenses and liabilities are subtracted, and the resulting net value is divided by the total number of units held by all investors. This calculation is done by the AMC at the end of every trading day.
Conclusion: A Prudent Path to Diversification
For investors wondering about a suitable diversification strategy for beginners, using mutual funds and ETFs is often the most recommended approach. It eliminates the complexity of individual stock picking and provides a low-cost, efficient, and disciplined way to build a balanced portfolio. By combining different types of funds—such as domestic equity funds, debt funds, and international ETFs—an investor can construct a resilient portfolio designed to navigate various market cycles and achieve their long-term financial goals.
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Disclaimer: This blog post is intended for informational purposes only and should not be considered financial advice. The financial data presented is subject to change over time, and the securities mentioned are examples only and do not constitute investment recommendations. Always conduct thorough research and consult with a qualified financial advisor before making any investment decisions.