Investors like mutual funds because they are a simple way to diversify one’s portfolio on a cost-effective basis.
When investing in funds, individuals need to ensure that they are truly diversifying. Often investors think they are diversifying, but in actuality they are not doing an effective job.
Today, we will take a look at ways to ensure you properly diversify. Our focus will be portfolio concentration.
Understanding and properly utilizing diversification is crucial for investing success. For a refresher, please review my earlier posts: “Introduction to Diversification”; “Diversification and Asset Correlations”; “Asset Correlations in Action”; “A Little More on Diversification”.
Intra-Fund Portfolio Analysis
When analyzing a fund for investment, consider the diversification within the specific fund.
To do that, review the fund’s investment portfolio.
Concentration of Key Holdings
Your focus should be on the largest holdings as a percentage of the total portfolio.
I like to look at the top 10 holdings and often even the top 3 or 5 investments as well.
You want to ensure that a small number of investments do not have too great an influence on the fund’s total performance. If this occurs, the benefits of diversification may be reduced.
There is no magic number as to what proportion should make up the top 3, 10, or 20 holdings. The right mix will differ depending on the type of fund and the views of each investor.
For example, JPMorgan U.S. Large Cap Core Plus Fund (JLPSX) is a U.S. equity fund that invests in U.S. domestic companies. The fund owns shares in 162 different companies. Pretty diverse, no?
But what if I tell you its top 3 holdings account for 10.69% of fund assets? Its top 10 holdings account for 28.26%? Some might view these percentages as a little high given the breadth of available investments. They may not see it as so diverse a fund. Others may not. In fact, probably a normal distribution for many large funds.
If we compare that with the Fidelity® China Region Fund (FHKCX) equity fund, we see less diversification. The China fund owns 80 companies, so sounds diverse. But its top 3 holdings make up 25.69% of the fund’s assets and its top 10 holdings are 39.97%.
Even though a fund may hold 80 or 100 different companies, it may be much less diverse than one expects.
Be Cautious with Specialized Funds
The more specialized an investment style, the less possible investments exist for inclusion in a fund’s portfolio. The less available investments, the greater potential for poor diversification.
The investment universe for JPMorgan U.S. Large Cap Core Plus Fund should be significantly larger than for Fidelity® China Region Fund. As such, I would expect more diversification within the JP Morgan fund relative to Fidelity.
When analyzing niche funds, it is important to take this into consideration.
Another diversification consideration for many specialized funds is that there will be a high degree of correlation between the assets held in the fund.
For example, consider the Oppenheimer Gold & Special Minerals Fund Class I (OGMIX). 91 holdings, so nice diversification. At least in number of companies. However, the top 3 holdings make up 20.35% of the fund assets. And the top 10 comprise 45.88%. Not as diverse as the 91 holdings may indicate.
Further, as the name states, this fund is exposed to a very narrow niche of assets. The JP Morgan fund has the largest investment universe of the three funds. It diversifies among many sectors and its main emphasis is in Technology (19.5%), Financial Services (18.12%), and Industrials (14.17%). The top three sectors only account for 51.79% of the entire fund. Lots of other sectors are well represented.
The Fidelity fund is narrower in focus, reflecting less opportunities in China. Its main sectors are Technology (41.06%), Consumer Cyclical (16.69%), and Financial Services (12.62%). These three make up 70.37%. Much less room for other sectors to impact. And the sole focus of the Oppenheimer fund is Basic Materials (99.82%).
Comparison to Peers and Benchmarks
As with all other analysis, compare a fund’s diversification against its peers and components of its benchmark.
For example, let us use the JPMorgan U.S. Large Cap Core Plus Fund from above. The fund holds 162 different companies. Its top 3 holdings make up 10.69% of fund assets. Its top 10, 28.26%.
Other U.S. Large Cap Blended Funds include the BlackRock Advantage Large Cap Core Institutional (MALRX), Goldman Sachs US Equity Insights A (GSSQX), and Janus Henderson Growth And Income A (JDNAX). Also, according to the JPMorgan profile, suitable benchmarks may be the Russell 1000 or Standard & Poors (S&P) 500 indices.
Just looking at each fund’s holdings, we see the following for their top 3 and top 10 percentages of total holdings: BlackRock at 8.16%, 21.24%; Goldman Sachs at 6.8%, 19.48%; Janus at 11.82%, 32.11%. Some differences, but JPMorgan is within the grouping of peers.
If we compare to the Russell 1000 or S&P 500 indices, the differences are more pronounced. The Russell 1000 index top 3 and top 10 holdings make up 8.45% and 18.13% respectively. The S&P 500 are 9.48% and 20.24%. JPMorgan is more top heavy in holdings than the benchmarks. Probably not a cause for concern, but there is a difference.
Again, this is not surprising. The benchmark contains all its holdings, both strong and weak. One expects that the fund manager would avoid the obvious weak components of the benchmark index and over-allocate to components that the manager expects to outperform. Hence, you would expect a greater concentration in certain holdings.
Of course, whether the fund manager is correct in his allocations is a topic for another day. And the greater the variance from the benchmark, the more questions that should be asked.
As we are getting a little long on the topic, I will break this subject into two parts. Please tune in next week for a look at Inter-Fund Portfolio Analysis.
