Whether you own too many or too few funds in a portfolio, the problem is the same: a lack of diversification from either overexposure or underexposure to any one sector, asset class, portfolio manager or company. Although there’s no magic number of funds to hold, your investing horizon, age and risk tolerance can help narrow down the number to a preferred range.
For instance, Rich Messina, E-Trade’s senior vice president of investment product management, says his clients typically own between six and nine exchange-traded funds. These clients, he adds, are long-term investors who want “adequate diversification” while seeking moderate growth.
Tim Barron, CIO of Segal Marco Advisors in Chicago, suggests five to 15 funds in a portfolio, depending on the investor and the variety of asset classes held. But instead of zeroing in on a hard number of funds to own, Barron says, think about how to get the diversification of both assets and managers that you need.
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Active versus passive. Investors who rely solely on passively managed funds, such as the Vanguard Total Stock Market Index Fund (ticker: VTSMX) or the Vanguard 500 Index Fund Investor Class (ticker: VFINX), which tracks the Standard and Poor’s 500 index, don’t have to worry about manager diversification because there is no manager.
Unlike index funds that track a market benchmark, however, actively managed funds have managers who try to outperform a benchmark like the S&P 500. In that case, investors should avoid having 10 to 20 percent of their assets with a single manager, Barron says.
“You want to avoid someone going off the rails, because they might underperform the market by 1,000 basis points, which is 10 percent,” Barron says. For someone who has 20 percent of assets with that manager, that equates to 2 percent of that investor’s portfolio.
Diversity, timeline and risk. Having exposure to many different asset classes is one thing; risk is another. Your investing horizon and goals will help determine how much to allocate to certain asset classes, keeping risk in proportion.
Typically, there are eight to 10 asset classes a client will want to hold in a portfolio, says Greg Kurinec, a retirement planner and financial advisor with Bentron Financial Group in Downers Grove, Illinois. These may include large-cap, mid-cap, small-cap and international stocks; corporate and government bonds of different durations; and real estate as an alternative asset class.
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While an investor with a high risk tolerance may need only four mutual funds or exchange-traded funds to be diversified, a retiree may want to add two or three fixed-income mutual funds or ETFs to reduce risk or generate additional income, says Clint Bauch, president and CEO of Park Capital Management in Madison, Wisconsin.
Risk and investment horizon are connected. Someone with a shorter time to invest may need less asset variety and more fixed-income investments, such as core bonds or a secure portfolio of Treasurys. A long-term investor, on the other hand, will want to have a broad range of assets, such as foreign and domestic stocks, emerging markets, high-yield bonds and real estate.
The return needed to meet an investing goal also dictates how much risk an investor is willing to take. Investors should track portfolio returns against that objective to determine how close or far off they are, and then decide if they should deviate from their target allocation, Barron says.
A portfolio that is well diversified across asset classes typically requires more than four specialized funds, Kurinec says. This could mean using balanced funds, which include a mix of stocks and bonds, as a strategy to keep the total number of funds in the portfolio to a minimum. Or it may mean other avenues, like Dimensional funds, a type of low-cost mutual fund that only certain advisors can sell. Dimensional funds use “modern portfolio theory” that aim for the highest potential gain for the lowest amount of risk. It’s based on the philosophy that small-cap equities historically earn more than large-cap, and value companies usually earn more than growth companies over a long time, Kurinec says.
“Either way, investors need to understand, what a fund is called means nothing; what it actually does means everything,” Kurinec says.
Overlapping shares. Funds that appear different at first glance may be strikingly similar on closer inspection. “Different funds can hold the same stock positions, even if those funds are from the same fund family,” Kurinec says. “When purchasing funds, take a look at the underlying holdings to make sure that there is not too much overlap in your account.”
For example, say an investor is trying to cover all asset classes and has a balanced fund of stocks and bonds, a growth fund with stocks that are expected to increase in value, and an income fund designed to generate a revenue stream for the investor. All three funds could own AT&T ( T) stock because it’s a blue chip that pays a dividend and is also suitable for both growth and balanced funds. As a result, that investor may have unwittingly bought AT&T shares three times.
To avoid overlapping shares, investors should do a holding analysis of their portfolio by comparing what each fund invests in. Kurinec says that the top 10 holdings shouldn’t constitute more than 5 to 7 percent of the total portfolio.
Costs and results. Kurinec also cautions against buying so many funds that you incur unnecessary trading costs. You should also consider the expenses each fund charges. This is particularly important for actively managed funds, which cost more than index funds.
“If the results mirror the index, the investor is probably paying big fees and not getting anything,” Barron says.
[See: The Fastest Ways to Lose Money in the Stock Market.]
To determine whether the fund’s results are worth paying for, Barron says investors should compare the fund’s return in your portfolio with that of the fund’s benchmark, such as the S&P 500 for stocks and Bloomberg Barclays US Aggregate Bond Index for bonds. That comparison should look beyond the past quarter or year and include performance over a rolling three-year period. Compare the fund’s percentage gain or loss to that of the S&P 500, for example, which was up 8.7 percent through the end of May, Barron says.
“The idea is that sometimes active managers lose, and sometimes they beat the market, but over the longer term they win more than they lose,” he says. “If not, consider another strategy.”
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How Many Funds Does Your Portfolio Need? originally appeared on usnews.com
