Mutual Funds: Diversification II

In Mutual Funds: Diversification I, we considered the level of diversification within a potential mutual fund.

There may be 100 plus holdings in a fund, but that does not guarantee a well diversified mix. I recommended reviewing the percentage of total fund assets held in the top 3, 10, or 20 holdings. If the fund holds 100 companies, but the top 10 holdings make up 40% of total assets, the fund may not be as diversified as you expect. As well, you should compare the concentration of key holdings between different funds within the same peer group and benchmarks. The distributions should be similar. If not, ask why.

Next, consider the inter-fund portfolio analysis of assets. If you invest in multiple funds, it is equally important to compare actual holdings between the different funds. If not, you may end up with too much exposure to the same investments.

Avoid Investing in the “Same” Fund Twice

In essence, you pay additional management fees for acquiring the same assets. A poor recipe for successful investing.

In our Part I example, I chose the JPMorgan U.S. Large Cap Core Plus Fund (JLPSX). We compared the top holding percentages to three other U.S. Large Cap Blended Funds: BlackRock Advantage Large Cap Core Institutional (MALRX); Goldman Sachs US Equity Insights A (GSSQX); Janus Henderson Growth And Income A (JDNAX).

The top 10 holdings for all four funds ranged from 20-30% of total fund assets.

Now we want to look for the level of overlap between the funds.

All 4 funds have Microsoft and Apple in their top 10 holdings. Not significant, but still a doubling up of 2 core holdings.

If we look a little deeper to the top 20 holdings, we see that 3 funds all share stocks such as Google, Texas Instruments, McDonald’s, Amazon, and Facebook. Roughly half the top 20 holdings are the same from fund to fund. Not surprising given the funds are from the same style.

When investing in multiple funds within the same investment category, you will often see duplication of holdings.

Funds of Similar Styles May Have Similar Returns

Also, with similar exposures, I would expect that the gross fund returns for these funds to be close.

In fact, as at May 8, 2018, their annualized total returns for the prior 3, 5, and 10 years were respectively:

JLPSX: 8.98%, 12.50%, 9.57%;

MALRX: 10.50%, 12.61%, 8.29%:

GSSQX: 10.34%; 13.11%, 8.73%:

JDNAX: 10.92%, 12.21%, 7.89%.

The difference in performance is likely due to: some differences in investment selection; the timing of purchases and sales of holdings; management fees and the total expense ratios; etc. But surprisingly, or not, very little difference in annualized returns over 3, 5, and 10 years.

Not to get ahead of ourselves, but let me add the S&P 500 return to the above data. The S&P 500 is a suitable benchmark for the above funds. However, it does not have experts buying hot stocks and selling dogs. It just sits there passively. One might expect this poor unattended benchmark to pale in performance versus the expert active managers. Or not.

S&P 500: 10.35%, 12.66%, 9.02%.

Professional stock picker or not, it is very hard to beat the passive index benchmark over time. But we shall save a favourite topic of mine, the active versus passive management debate, for later.

For now, just remember that there are often big similarities between funds in the same investment category. If you want to diversify in funds, make sure that you are not buying essentially the same fund under a different name.

Another Issue with Speciality Funds

This is also a problem with specialized investment styles, geographic regions, niche investments, etc.

The smaller the number of investment options, the more likely that funds within the same style will have common holdings.

If you intend to acquire specialized mutual funds, I suggest you limit your investment to one fund in each category.

While you may not always end up with the top performing fund, you will avoid potentially overlapping your underlying investments and paying extra fees.

Be Careful Across Styles As Well

Some investments seem to crop up in many different investment categories.

Apple is always a culprit. I have seen it in growth funds, value funds, tech funds, etc. The popular stocks often find their way into many fund holdings. In Canada, the major banks seem to be everywhere.

Just because you own two mutual funds of differing style, you may end up with some similarities in holdings.

For example, in Canada you might own a Canadian Large Cap Blended fund, the PH&N Canadian Equity Value D. You would like some diversity. Perhaps something with smaller companies, the Mackenzie Canadian All Cap Value D. To counter the value funds, we will purchase a growth fund, the IA Clarington Canadian Growth Class A. And let us add in some dividend income in the Meritas Monthly Dividend And Income Series F. A nice mix of investment styles.

Four “different” funds. Yet the major Canadian banks appear in all. Within the top 15 holdings, all the above funds own significant amounts of Royal Bank, Canadian Imperial, Toronto Dominion, Nova Scotia, and Montreal. Only Meritas does not include Canadian Imperial or Montreal in its top 15.

In a relatively small market like Canada, the significant companies often are held by many funds. Regardless of their being labeled value, growth, equity, or dividend.

Always make sure you check to avoid getting too much exposure to any one holding and that you are attaining the diversification you desire. Never simply rely on the fund name or description of its investment style. Dig deeper into the actual fund portfolio holdings.