Too many
funds - a recipe for underperformance
Allocate
your eggs among many baskets. Diversify. Hold a balanced portfolio. These are
all variations of an age-old rule of investing that is so engrained in our
minds that the words just roll off of our tongues almost effortlessly. Problem
is, most people fail on execution. That is, they do spread things around – but
do so at the expense of performance potential. This week, I’ll explain how too
much of a good thing may be bad for your financial health.
Diversifying
one’s portfolio is a common term used to describe the spreading of proverbial
investment eggs among many baskets. Generally speaking, the potential for
higher returns can usually only be obtained by taking more risk. The concept of
diversification is rooted in the academic world, where it was shown that
combining assets that are less than perfectly correlated has potential to
improve the tradeoff between risk and return.
Consider an
example where an investor holds two investments that move exactly opposite to
each other but, over time, generate identically positive returns. Suppose
investment A loses 10 per cent in its first year, and generates a positive
return of 30 per cent in the following year. Buying at the beginning of that
period and holding until the end would have resulted in an average return over
two years equal to 8.2 per cent per year – but it would be quite a ride.
Further
suppose that you had added investment B to your holdings, which had a return
pattern that was exactly opposite to A – a positive return of 30 per cent in
year one, and a loss of 10 per cent in year two. Same return, same variability,
but exactly opposite pattern. In other words, investment B is perfectly
negatively correlated with A.
Putting
half of your money into each A and B at the beginning of the period, and
holding, would have yielded the same return, but with remarkably less risk and
variability. The result would be a positive return in each of the two years: 10 per cent in year one and 6.4 per cent in
the second year. See what’s happened here? The average return is the same – 8.2
per cent per year – but the large swing from big loss to even bigger gain is
eliminated.
Potentially,
the power of diversification is significant. Equally important to keep in mind
is the fact that diversifying investments provides a diminishing benefit. In
other words, as you continue to add each diversifying investment to your mix,
the incremental improvement in the risk/return relationship decreases. In
reality, it’s extremely difficult to find two investments with such nicely
offsetting return patters as we’ve illustrated. However, in order for
diversification to work, such perfectly negative correlations are not required.
At
January’s Financial Forum in Toronto, I spoke to a group of keen investors
about steps they could take to improve their investment returns. One of the
points I harped on: Don’t hold too many
mutual funds. Five to eight funds will do the trick for just about any
portfolio. After one of my presentations, a financial advisor approached me
asking: If you’re buying more of a good
thing, what’s the harm?
I’ll agree
that if you buy two investments that are virtually identical, you’re not doing
any harm. You’re not diversifying, but you’re also really holding one fund for
practical purposes. An example like this would be a portfolio holding both Ivy
Foreign Equity and Ivy Foreign Equity RSP. They are technically different
funds, but they effectively offer exposure to the same group of stocks.
Diworsification
(diversifying to a fault) occurs when two (or more) similar funds are held in
the same portfolio. Let’s use Mackenzie Ivy Canadian and Trimark Canadian as
examples since both are often found in mutual fund portfolios that I review.
Both are good value-oriented large cap Canadian stocks funds.
While
they’re generally similar in style, they are far from being identical. And
while both are good funds, holding both together exemplifies the statement:
“too much of a good thing may be detrimental”. Here’s why.
Among the
roughly 1,400 stocks trading on the Toronto Stock Exchange (TSE), only about 60
could be considered “large caps”. If all you want is to replicate the
performance of this large cap universe, there exist many index fund products to
satisfy you. But if you’re buying any other type of investment fund, you’re
betting your pick can beat that stock universe. Proportionately, the greater
number of those sixty stocks you own, the lower your chances of beating the
group.
Using data
from December 2001 annual reports, Trimark Canadian holds 34 Canadian stocks,
while Ivy Canadian holds 24. In total, eight Canadian stocks are common to both
funds – accounting for 22 per cent of Trimark Canadian’s assets and 31 per cent
of Ivy Canadian. That means holding both of these funds together exposes the
investor to 50 unique Canadian large cap stocks (34 + 24 – 8 = 50). I would say
that holding 25 to 30 stocks gives you a better chance of outperformance than
would 50.
For
example, as of the end of 2001 Trimark Canadian held Royal Bank, Bank of Nova
Scotia and TD Bank. Ivy Canadian held Royal, CIBC, TD, and Bank of Montreal.
The only major bank missing is National Bank. I’m not saying bank stocks are
good or bad, but I think you’ve got a better chance of success by holding two
or three, rather than nearly all of them.
The more
similar your Canadian stock exposure is to the 60-stock large cap index (i.e.
the S&P/TSE 60), the greater the likelihood of index-like performance. But
funds that aim to beat the index charge substantially more in fees. In effect,
a portfolio holding too many funds emphasizing each asset class may well be
destined to deliver mediocre performance.
I don’t
have room to get into specific suggestions on how to put together portfolios.
However, keep your eye out for the May issue of Canadian MoneySaver magazine (http://www.canadianmoneysaver.ca).
In it, I author an article entitled “Implementing the ‘Value Core’ Strategy”,
which discusses how to structure portfolios and offers specific sample mixes
that people can use as a guideline for building their own mutual fund
portfolios.
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.