There’s Safety in Numbers but What Number?
It’s common for investors to think that more is better. More stocks. More bonds. More assets all around.
But in the case of mutual funds, an excessive number of holdings can unnecessarily complicate your financial life. You will have more investments to keep track of and more record-keeping demands.
Sometimes too many funds can work against you. Suppose you own four or five blue-chip stock portfolios. “It’s conceivable that one manager might be buying Coca-Cola at the same time another’s selling the stock,” says Gerald Perritt, editor of the Chicago-based Mutual Fund Letter. “All you would get is the transaction costs.”
Perritt recalls the time when he analyzed the holdings of some subscribers to his newsletter as a promotional tool to get them to renew. “We found that some people owned 20 to 30 funds,” he says. “They had become mutual-fund junkies.”
If 20 or 30 holdings are overkill, what’s the optimum number of funds?
That depends largely on the type of funds you own, your appetite for risk and the amount of money you have to invest.
People with $10,000 to $15,000 or less might be better off trying to save the money rather than invest it, especially if they couldn’t afford to sustain losses. For individuals in this group, J. D. Montgomery, a financial planner with IDS Financial Services in Irvine, suggests sticking primarily with certificates of deposit and tax-exempt money market funds.
Alternatively, smaller investors might consider purchasing a single mutual fund that combines safety with some growth potential. Balanced funds would be a good choice. They hold a combination of common stocks and bonds, with a smattering of cash. They tend to post higher gains than bonds, with less risk than stocks.
“One balanced fund might do the trick for some people,” says Bruce Grenke, a principal at Asset Allocation Advisors, an investment management firm in Walnut Creek, Calif. He suggests selecting a fund with low expenses and a veteran portfolio manager who has compiled a steady track record.
However, balanced funds can’t cover all the bases. They don’t invest in precious metals, for instance, and most shy away from small growth stocks and international securities.
Asset allocation funds take the balanced approach a step further by investing in these additional areas too. Yet there aren’t many of these funds, and most haven’t been around for more than a year or two. Instead, Perritt suggests building your own asset-allocation portfolio with proven funds in different categories.
He recommends a multifund approach that can be followed by anyone with $15,000 or so to invest. He suggests buying a fund in each of these seven classes: large stocks, small stocks, international equities, international bonds, U.S. bonds, precious metals and money markets. Perritt recommends more or less equal investments in these categories, with periodic adjustments to bring the weightings back in line.
A multifund strategy offers a couple of advantages. First, you can select the best fund you can find in each category. Second, you can diversify by portfolio manager.
Perritt says his seven-fund “all-weather” portfolio would have returned about 12.5% a year on average during the 1970s and 1980s, compared to about 11.5% a year for blue-chip stocks and 7.6% annually for Treasury bills. These results assume that you selected funds that performed in line with their respective group averages.
Grenke also suggests spreading your dollars into as many as seven fund categories. But unlike Perritt, he recommends adjusting the mix to reflect the current state of the economy and markets.
Currently, his firm has a cautious outlook for the stock market. The company’s model portfolio, designed for conservative investors, includes the following weightings: 33% in short-term bond funds, 33% in stock funds, 24% in money market funds and 10% in long-term bond funds.
However, if you want a truly diversified mix of funds, you need some international exposure. The reason: Foreign stocks and bonds don’t move in sync with U.S. markets. “By themselves, international funds can exhibit fairly high risk, mainly due to fluctuating currency rates,” says Jeff Madura, a professor of finance at Florida Atlantic University. “But when combined with other types of funds, they offer diversification benefits.”
Madura and John M. Cheney, a finance professor at the University of Central Florida, studied how different fund categories can be combined to reduce risk without hurting returns. They reached some surprising findings.
For example, Madura and Cheney determined that a portfolio with 77% in money markets, 17% in international stocks, 3% in corporate bonds and 3% in U.S. growth stocks produced a greater return--with less volatility--than the money fund alone.
Madura and Cheney also found that a combination of just three or four funds can reduce risk substantially--especially if the mix includes an international and a money market selection.
Investors often mislead themselves when they look at each fund independently to evaluate risk, says Madura. “By itself, a Treasury or corporate bond fund will normally appear less volatile than another category,” he says. “You’ve got to ask, ‘How does it move together with other funds?’ ”
Of course, if you want to limit yourself to just one fund in a particular category, make sure it’s a good representative of its class. An international fund that concentrates on Japanese stocks, say, or Australian bonds won’t move in the same fashion as a portfolio diversified among many countries.
Even with U.S. funds, you should be careful. Fidelity Magellan and Twentieth Century Growth, for example, both exhibit more volatility than the Mathers Fund, even though all three fall within the “growth” category. The difference: Magellan and Twentieth Century Growth stay nearly fully invested in stocks at all times, while Mathers frequently retreats to the safety of cash.
So, there’s no simple answer to the question of how many mutual funds you should own. If you have a small amount of cash, a single, balanced fund can deliver reasonably good returns with modest risk. Assuming you can’t afford to sustain any losses, you might forgo stock and bond funds entirely in favor of savings-oriented instruments.
If you have $10,000 to $15,000 or more to invest, you can get good diversification by purchasing a minimum of three to seven funds, including a money market and an international selection.
With your bases covered, you can then add to your holdings in certain areas. Suppose you have a penchant for growth stocks. You might add a second fund in that class, to diversify by portfolio manager and increase your weighting.
Just be careful not to get too much overlap in any one area at the expense of another. “Don’t stock up on many funds in the same category,” Madura says. “Rather, spread your money across different types of funds.”
DIVERSIFYING AMONG FUND CATEGORIES
How many mutual funds should you hold? Finance professors Jeff Madura and John M. Cheney conducted a study that helps answer that question.
They researched the performance and risk of seven types of funds from 1978 through 1987. They defined risk in terms of volatility--the amount by which returns varied from the average. Greater volatility translates into increased risk.
Madura and Cheney concluded that holding at least three or four types of funds can sharply reduce risk compared to investing in a single category.
Average annual Volatility Portfolio return (risk) 100% international 20.3% 19.2% 100% growth stock 16.2% 14.1% 48% international, 36% growth stock, 16% money market 17.1% 11.8% 100% corporate bond 9.7% 10.5% 55% money market, 29% international, 16% growth stock 14.0% 6.2% 100% money market 9.9% 3.4% 77% money market, 17% international, 3% corporate bond, 3% growth stock 11.8% 3.0%
HOW MUTUAL FUNDS PERFORMED
Average total return, including dividends, in percent for six months ended Friday, June 29.
TOP 10
Fund Type Yr. to date Fidelity Sel Electronic TK +36.90% Fidelity Sel Bio Tech H +30.40 Equity Strategies S +29.92 Federal Sel Computer TK +29.69 Financial Port: Tech TK +29.00 Bull & Bear SPL Equities CA +26.61 Oberweis Emerging Growth SG +26.29 Cowen Funds: Opportunity TK +22.16 Alliance Technology TK +22.05 T Rowe Price SCI & Tech TK +20.26
BOTTOM 10
Fund Type Yr. to date Strategic Investments AU -39.68% US Gold Shares AU -26.74 Nikko Japan Tilt FD PC -23.61 US New Prospector Fund AU -22.86 USAA Inv Tr: Gold AU -22.62 Blanchard Prec Metals AU -22.35 Thomas McKinnon: PR MT AU -21.49 Van Eck: Gold/Resources AU -21.39 International Investors AU -21.28 Keystone Prec Metals AU -21.20
TYPE: AU=gold, B=balanced, CA=capital appreciation, CV=convertible securities, EI=equity income, EU=European regional, FI=fixed income, FS=financial securities, FX=flexible portfolio, G=growth, GI=growth and income, GL=global-international and U.S. stocks, GX=global flexible portfolio, H=health/biotechnology, I=income, IF=international, MI=mixed income, NR=natural resources, OI=option income, PC=Pacific regional, RE=real estate, S=specialty/misc., SG=small company, TK=science and technology, UT=utility, WI=world income.
Source: Lipper Analytical Services
