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Dangerous Diversification

Investors are constantly told to diversify, diversify, diversify. The main reason to diversify is to prevent catastrophic losses. If structured properly then diversification may also allow for increased returns with a lower level of portfolio fluctuation. These benefits sound great but diversification is mainly a stock concept and can be dangerous when applied to fund portfolios. Mutual fund diversification can quickly 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 most investors with an adequate level of diversification. A two-fund portfolio could 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 good coverage of U.S. blue-chip stocks. In Canada the pickings are slimmer and the equivalent blue-chip index is the S&P/TSX60 which contains only sixty stocks. 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 look at a small fund portfolio with equal amounts of the Spectrum Canadian Equity fund and the Elliott & Page Equity fund. Both funds try to beat the market by investing in large Canadian companies. In other words, they'll both be buying stocks in the S&P/TSX60.

The Spectrum Canadian Equity fund held sixty-three Canadian stocks at the end of March and charges a MER of 2.57%. The Elliott & Page Equity fund held thirty-eight Canadian stocks and charges a MER of 2.45%. By buying equal amounts of both funds you would hold an interest in 52 out of the 60 stocks in the S&P/TSX60 index. That's over 86% 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 Spectrum and Elliott & Page funds would have an effective MER of 2.51%. 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. The two-fund solution is clearly unattractive and is a simple 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 larger U.S. 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 funds help investors to improve the odds of building a winning portfolio.

First published in September 2002.

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