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Q1/6 Focus on ETFs
Q4/5 LW Canadian Equity
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Q1/2 Mawer U.S. Equity







Dangerous Diversification

Investors are constantly being told to diversify, diversify, diversify. The motivation for the diversification mantra is that it can help to prevent catastrophic losses. It may also allow for increased returns with a lower level of portfolio fluctuation. These benefits sound great but diversification mainly applies to stocks and not to fund selection. Mutual fund diversification can easily get out of hand and wind up costing investors a lot of money.

Most equity mutual funds hold anywhere from twenty to over one hundred stocks with the average fund owning about fifty. From a stock point of view, fifty stocks should provide an adequate level of diversification. A two fund portfolio may well represent ownership of over 100 stocks. Owning 100 stocks may not seem to be much of a problem but I've seen fund portfolios that contain more than twenty funds. A twenty fund portfolio could translate into owning an interest in over 1,000 stocks. At this point the massively diversified fund investor owns an interest in so many stocks that their portfolio starts to look remarkably like a broadly based index fund.

Consider that the U.S. based S&P500, which is composed of 500 stocks, provides a good sample of U.S. blue-chip stocks. In Canada the pickings are slimmer and the equivalent blue-chip index is the S&P/TSX60 with only sixty stocks. It is easy to see that by owning too many funds an investor can quickly wind up owning a portfolio that is very similar to an index fund. All at many times the cost.

Let's consider a small fund portfolio with equal amounts of the BMO Equity fund and the TD Canadian Blue-Chip Equity fund. Both funds try to beat the market by investing in large Canadian companies. In other words, they'll both be fishing in the same S&P/TSX60 pond.

The BMO Equity fund held fifty Canadian stocks at the end of last year and charges a MER of 2.38%. The TD Canadian Blue Chip fund held forty-seven Canadian stocks and charges a fat MER of 2.44%. By buying equal amounts of both funds you would hold an interest in 47 out of the 60 stocks in the S&P/TSX60 index. That's just over 78% of the index. Sure there are some differences. For instance, the index doesn't hold exactly the same amount of each stock as the fund combination. But even at two funds there is a considerable amount of overlap.

Think about how much worse the situation would get if you added just one more Canadian equity fund to the mix.

Now let's look at the costs involved. Investors can easily buy a low-cost S&P/TSX60 index fund. In this case, the XIU exchange-traded fund (ETF) listed on the TSX would be suitable. ETFs trade just like stocks but are otherwise very similar to index funds. The main advantage of the XIU ETF is its modest MER of 0.17%. On the other hand, the equal combination the BMO & TD funds would have an effective MER of 2.41%. The fund combination is over 14 times more expensive than the index. That's 14 times the cost to buy a very similar collection of stocks. Any way you look at it the fund solution is unattractive. It's a clear case of selecting too many expensive funds.

For Canadian equity funds I suggest sticking to a maximum of one fund for large stocks and one fund for small stocks. The U.S., with its larger market, can accommodate more funds but I'd still stick to a maximum of two large company funds and two smaller company funds. In general, a fund portfolio that holds more than ten mutual funds probably suffers from over diversification.

Naturally one can go for a combined core and explore' approach. Here the investor holds index funds as the core' of their portfolio and one or two actively managed funds for exploration'. Either way, both index funds and actively managed funds should be selected primarily on the basis of cost. Low cost, Frugal Funds, help investors to improve the odds of building a winning portfolio.

 

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