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Diworsification
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.

Diversification

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.

Holding too many funds - a bad idea

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.

Trimark + Ivy = Diworsification

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.

Reading assignment

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. 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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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