HOW MANY FUNDS IS TOO MANY?

Does anybody remember what the whole point of the mutual fund was supposed to be? It was to provide diversification in one packaged portfolio of securities. Well, it looks like that idea has snowballed - and possibly gone too far. Ten years ago, a technology fund would have sounded a little over the edge, so I'm sure nobody imagined we'd have a fund that specializes strictly in Internet companies or India. In the US they've sliced and diced market sectors to death. Even index products are getting into the game by offering sector specific index units. What all of this does is create an insatiable hunger to buy (and unfortunately trade) specialty investment funds. The result, more often than not, is a portfolio which appears to have been structured by an "impulse shopper".

I have reviewed countless portfolios and although I haven't formally kept track of this statistic, I can tell you that most portfolios had somewhere between 15 and 20 funds amongst their various accounts. What many individuals and advisors will ask is "what's wrong with holding a lot of funds?". And my answer to them is that there is nothing inherently wrong with it, but what results are a few common problems.

I - COMMON PROBLEMS

High Fees

Investors who can't stop themselves from collecting funds like they do baseball cards invariably do so to catch a piece of the hottest sector going. These days, things like biotechnology and e-commerce are still white hot with investors, despite the recent weakness in the prices of tech stocks. Funds that focus on a particular sector or geographic region have relatively high fees - usually starting at 2.50% and often reaching over 3.00% annually. So a natural by-product of holding many such funds is the problem of high fees. Investors should try to think of their MERs in dollar terms. For instance, a 2.50% MER on a $50,000 portfolio adds up to $1,250 each year (and that figure grows as the portfolio grows). So while you don't physically write a cheque for that amount, don't kid yourself by thinking you don't pay it - you do - and it hits your bottom line directly.

Lack of Diversification

Go much beyond eight funds, and you're likely to have poor diversification and/or a lot of overlap among your holdings. For example, one portfolio I reviewed recently had six Canadian equity funds - and that's not including the Canadian balanced funds also included in the mix. The Canadian market simply isn't big enough to warrant that type of coverage. What you end up with is a lot of different portfolios holding many of the same stocks.

Mediocre Performance & Excess Risk

Though these are separate problems, they go hand-in-hand. When you have a portfolio with lots of overlap, you unwittingly become overexposed to certain stocks and sectors. The end result is that you are kicking portfolio risk up a notch or two. This excess risk may not be apparent during shorter-time periods but it will eventually make an appearance. More risk doesn't automatically result in higher returns; and when it does it's not always worth it. Excess risk in a portfolio that is not well-structured may likely suffer mediocre or poor returns because down periods may be more severe or more frequent.

None of these problems is really serious since they can be easily remedied. What follows are a few guidelines to help you clean up your current portfolio or to help guide you if you're about to invest in a new portfolio.

II - RULES OF THUMB

Canadian Equity (2)

This is where most Canadians have their money since RRSP accounts are restricted by the 25% foreign content limit (30% in 2001). As mentioned above, the Canadian stock market is simply not that large to warrant holding many such funds. All most investors need is two Canadian equity funds: one large cap value (or blended value/growth approach) fund, and one small cap growth fund.

Examples of good large cap Canadian equity funds are: ABC Fundamental Value ($150k minimum), AGF Dividend, Bissett Canadian Equity, C.I. Harbour fund (mid/large cap), Perigee Large Cap Value, and Standard Life Equity (or Canadian Dividend). These are just a few of the available funds that stand out as solid performers with great consistency and reasonable fees.

For small cap growth funds, take a look at Fidelity Canadian Growth Company, GBC Canadian Growth ($100 minimum), Mawer New Canada, Spectrum United Canadian Growth, and Talvest Small Cap Canadian Equity to name just a few.

Remember, the Canadian market isn't that big. All of the 1,456 companies listed on the TSE at the end of 1999 had a total market value of about $1.5 trillion (source: TSE financial review) - about as large as the four largest public companies in the US.

For larger portfolios or for those who really want broad coverage, a microcap fund or labour sponsored investment fund (LSIF) may be a good idea but treat is as a specialty holding. Great diversification, high growth potential, and unique tax credits (LSIF credits) are three good reasons to include this asset class.

Balanced (0)

There are two basic types of balanced funds - those that keep a relatively fixed mix of stocks, bonds, and cash (strategic asset allocation); and those that vary the mix according to the manager's economic forecasts over the next year (tactical asset allocation). Most of the funds available are of the "strategic" variety, and there are two good reasons not to own such funds.

First, the cost to own the funds (i.e. MER) is high in most cases. Remember that such funds usually keep a fixed mix of 60% stocks and 40% bonds and cash. These same funds typically charge about 2.30% per year in MER. So if bonds are only yielding about 6% (as they are now), that leaves 40% of the fund earning a meagre 3.7% (6.0 - 2.3). Keeping fees low on your bond component is important. The second reason strategic balanced funds aren't a good idea is that you usually end up buying more of the same thing, if you've already got a good chunk in Canadian equity funds. For example, buying Ivy Growth & Income really isn't all that different than buying Ivy Canadian. Yes, they're different, but they're not different enough to warrant holding both in the same portfolio. Just pick one. This is not just the case with "same-family funds", most balanced funds from one company are highly correlated to Canadian stock funds of another.

As for tactical asset allocation funds, there aren't many good ones around and you still end up with a lot of overlap when holding them together with other Canadian equity funds. But if you can't resist the urge, take a look at Fidelity Canadian Asset Allocation or AGF Canadian Tactical Asset Allocation.

All of the points made above regarding Canadian balanced funds also apply to foreign balanced funds. Bottom line: balanced funds can be good one-decision funds when just starting to build a portfolio, but they have their limits.

US Equity (2)

US stock markets account for about half of the world's total stock market value. Add to that the facts that the US is the nucleus of the global economy and home to the world's most profitable companies, and you've got the makings of big investment opportunities. Two funds would give you broad coverage here as well. With indexing being such a compelling argument in the US (keep an eye out for an upcoming report on indexing), there are two approaches that can be used.

First, one can index the larger cap portion of their portfolio by investing in a large cap index fund like Royal US Index or Altamira Precision Dow 30 Index (good RRSP eligible index funds are available from these same companies as well as TD and CIBC). Then offset this large cap passive approach with a small cap fund that offers great active management like, AGF Aggressive Growth or Mackenzie's Universal US Emerging Growth. There simply aren't many good US small cap funds around but these two are tops in this category.

Okay, you don't like the idea of a passive investment approach (i.e. indexing). So, instead of indexing your US large cap component, pick a value-oriented large cap fund with reasonable fees to offset the good small cap funds mentioned above. Funds like C.I. American, Dynamic Americas (great bear market performer compared to others), McLean Budden American Growth, and Royal & SunAlliance US Equity (a segregated fund) are all great core holdings for large cap US equities.

Global or Int'l Equity (1-2)

If you've got lots of North American exposure in your portfolio, you may want to focus more on Int'l Equity funds, which invest in Europe, Asia and the Far East (and have a policy to exclude North America). In this category, there truly isn't a lot of diversification to be had. Although many funds use different styles, the fact is that most funds in this category pretty well move together (i.e. most are highly positively correlated).

Great picks in this category include AGF International Stock, Mackenzie's Cundill Value (really a global fund but it's deep value and a great pick if you're nervous about the US), Mawer World Investment, Perigee International Equity, Standard Life International Equity and Templeton International Stock.

Specialty Holdings (1-2)

Media often quote people like me saying things like "limit this holding to 10% of the average portfolio". Well, unfortunately some investors hear that and buy five specialty funds, each making up 10% and occupying half of the aggregate portfolio. That 10% threshold should be for the aggregate of all specialty holdings and for each individually.

The idea here is diversification right? So don't go and buy more of what you already have. For instance, you had 10% of your portfolio in AGF Aggressive Growth, don't go plunking another 10% in a high tech fund. AGF Aggressive Growth is a great fund but one which typically has anywhere from 40% to 75% in technology. So, the strategy is to add holdings in areas to which you have little or no exposure.

For instance, with a basic structure like we've outlined above, you may be light on emerging markets or financial services. Or maybe you want to focus on an area that has been depressed lately. Whatever your motivation, make sure you get maximum diversification out of your choice(s).

A few standouts among the countless specialty funds available are AIM Global Health Science, BPI Canadian Resource Fund Inc.,C.I. Emerging Markets, C.I. Sector Global Financial Services, Dynamic Far East, Mackenzie's Universal European Opportunities, and Talvest Global Science and Technology.

III - FINAL COUNT

It's important to remind you that portfolio theory tells us (and this issue is not debated) that holding much more than 20 to 30 stocks in any one market has very limited (if any) diversification benefits. Remember that each fund holds as few as 25 stocks and as many as 300 or more. So holding more than two funds in any one broad category and/or more than 5 to 8 funds in total, and you may be doing your portfolio more harm than good.

Dan Hallett can be reach by e-mail at dhallett@sterlingmutuals.com

The information presented in this article is for information purposes only and is not a recommendation to buy securities. Neither the author nor Sterling Mutuals Inc. (or any affiliate) can guarantee the accuracy of the information contained herein. Always consult a professional financial advisor before making any decisions based on this material.