Combining Broad Market Indices Without Fooling Yourself

Does owning several index funds add diversification?

Kabir holds three index funds and has been assuming that three is better than one.

It depends entirely on what is in them. Broad market indices are usually built from the same universe of listed companies, differing in how many they include and how they weight them. Two indices drawn from the same universe, both weighted by company size, will have most of their value in the same handful of large companies — because that is what size weighting does.

So the second fund can be almost entirely a repeat of the first. You have three holdings, a second fund's charge added into the mix, and roughly one portfolio.

The question that resolves it is not "how many indices do I hold" but "what does the second one contain that the first does not, and how much of its value sits there?"

What can a second index fund add?

Three things, in descending order of how much they usually help.

Companies of a different size. An index of large companies and one of smaller ones hold genuinely different businesses, which behave differently from each other. This is the most substantive addition available within one country's shares, and it is also the one that adds real volatility — smaller companies fall harder.

A different weighting rule. An index weighted equally, or by some measure other than size, holds the same companies in different proportions. That is a real difference in behaviour, though a smaller one than holding different companies. It is also a decision to tilt, which has its own literature — how factor investing works.

A different country. The largest genuine addition, because the businesses, the economy and the currency all differ. It also introduces a risk that the others do not have, which is the currency itself — international equity and currency risk.

What almost never adds anything is a second index from the same universe with the same weighting rule and a different number of constituents. The extra companies are the smallest ones, so they carry the least weight, and the overlap does the rest.

Why is the number of funds the wrong measure?

Diversification depends on whether holdings move together, not on how many of them there are. Adding a fund that moves almost identically to one you hold reduces nothing at all — the mechanism is in how diversification works.

There is also an arithmetic trap in the weighting. If you put money into two overlapping indices, the companies present in both end up with a larger share of your portfolio than the broader index alone would give them — not larger than either fund's own weight, which a simple blend cannot produce, but larger relative to what a single broad holding would have held. Combining a broad index with a narrower one drawn from its own top holdings does not spread your money out; it concentrates it further into the companies they share, which is usually the opposite of the intention.

The way to see this is not to count funds but to look at the combined portfolio — how to do that is measuring concentration and overlap.

What does combining index funds cost?

An added charge is certain; the benefit often is not. Splitting money between funds does not multiply what you pay — ₹1 lakh split evenly between two funds each charging 0.2% still costs about ₹200 a year, the same as holding one, since the charge is blended in proportion to what sits in each fund. What does cost money is adding a fund that charges more than what you already hold, for exposure that mostly duplicates it: you have raised your blended charge and bought almost nothing with it. Either way, the charge is certain and the diversification benefit from a near-duplicate fund is often near zero, which is a bad trade whenever the overlap is high — how investment fees reduce wealth.

Rebalancing gets harder. More holdings means more decisions, more transactions and more tax events, and a portfolio complicated enough to be tedious is one that stops being maintained.

And complexity hides drift. With one or two holdings you can see what you own. With seven you generally cannot, and the concentration that accumulates through success becomes invisible.

How can index funds be combined sensibly?

Start with one broad index of your home market, which gets you most of what indexing offers in one holding.

Add a second only if you can say what it contains that the first does not and roughly how much of its value sits there. If you cannot answer that, the addition is not doing what you think.

Consider the two that genuinely differ — smaller companies, and another country — and size them deliberately rather than equally. Equal amounts across holdings of very different character is not a neutral choice; it is a large bet expressed as a tidy one.

Then stop. The decision that dominates portfolio risk is not which equity indices you combined but how much of your money is in shares at all, which is choosing an asset allocation.

What to take away

More funds is not more diversification. What matters is whether the second index holds different companies, in meaningfully different proportions, and whether enough of its value sits in that difference to matter.

For any specific pair of funds, the answer is in the fund's published portfolio: each fund discloses its holdings and their weights periodically, and the combined picture from the method in the overlap article will tell you more than any general rule can.

If you cannot say what a holding adds, it is adding a charge.