How Many Mutual Funds Are Too Many?
The golden rule to investing is diversification. In fact, mutual funds themselves is a great way for some investors to access instant diversification. One of the problems today is that investors have so much choice that it has become increasingly complicated and it is too easy to diversify a mutual fund portfolio. We’ve got a fund for everything and anything. You want technology, there’s a fund for that. And what about China? You bet, there’s a fund for that too. Income trusts, health care, gold, India, Germany, Alberta . . . there’s a fund for everything.
In my experience, I analyze numerous portfolios and what I typically see is that investors are holding more and more mutual funds in their portfolios. Add a little of this and a little of that and presto . . . you’ve got a portfolio with 15 to 20 funds. This is characteristic of the investor with no plan and great impulse to follow the latest trend.
What’s wrong with holding a lot of funds?
Great question. After all if diversification is the timeless principle of investing, then arguably the more funds the better, right? I’ve been asked what the optimal number of funds is for a mutual fund portfolio many times and I’ve often said you can get the job done with about 5 to 12 funds. Part of it depends on whether you have a high need for sophistication and a flavour for niche markets. Or whether you prefer good core type holdings.
The reality is that I’m not sure it is about how many funds you have but rather the types of funds that you own. Far too often, I see 5 to 7 funds in a portfolio that do the exact same thing. When one moves up, so do the other six. And when one moves down, so do the other six. In fact, someone has coined the term DIWORSIFICATION.
Correlation is an old statistical term that measures how things like investments move in relation to one another. Let’s look at the CI Canadian Investment Fund and the Mac Ivy Canadian Fund. Both funds are solid CORE Canadian Equity products run by experienced managers with excellent track records. They have a correlation of 0.9. What does that mean? Well, a correlation of 1.0 is what we call a perfect correlation, which means they move exactly alike. At the other end of the spectrum, a correlation of -1.0 is what we call negative correlation when they would move in perfect opposites. A zero correlation means that they do not move together. Thus a 0.9 correlation is a very high correlation or another way of saying we have two investments that do pretty much the same thing.
So now, if we use correlation as a tool, it is not about how many funds we add to a portfolio but rather adding funds that work together as a team to build a portfolio that manages risk and delivers performance.
Start with the categories
Like anything, the more money you have, the more sophisticated the approach. The most basic approach is to start with a few basic categories and usually you will only need one or two funds from each category. On the equity side, you should look into at least a global equity and a Canadian equity fund. More sophisticated investors will break out the global equity into more regional components like US, Europe and Asia.
On the fixed income side, you might consider global bonds, Canadian bonds and cash. Again, more sophisticated investors may want to incorporate high yield bonds and real return products.
Next, new asset strategies like income trusts, alternative assets and income products have worked their way in as separate asset classes.
Finally, the world of specialty funds can be added. One thing to keep in mind about specialty funds is they tend to have higher MERs, as thus using specialty funds should be limited in use. Stick with proven core holdings and use specialty funds to overweight favoured areas.
Once you’ve got this put together, you will need to get access to some correlation numbers. When in doubt, most financial advisors will have access to this data. All you want to do is make sure you do not have too much overlap in the portfolio. Once you get over 10 funds, there is a good chance that you will have overlap and highly correlated funds.
The final count
Try not to get too caught up in the number of funds but rather how the funds that you have in a portfolio fit together. It’s kind of like a car needs 1 engine, 1 steering wheel, 4 tires, 2 doors, etc. to form a complete vehicle that moves you. A car with 12 wheels and no engine is not going to work properly. Your portfolio is going to need different parts rather than more of the same parts. Take the time to understand what parts you need and then go out and select that part carefully. Chances are too many funds means diworsification.