Recently, I was reviewing a client’s account that is managed by a large retail brokerage company. The account had 31 mutual funds and a value of approximately $165,000. This equates to a little over $5,000 per fund. The funds were allocated to a diversified portfolio that was based on the client’s time horizon, investment goals, and risk tolerance (a strategic allocation). Most of the funds were highly rated by Morningstar.
My first thought was that having 31 mutual funds in an account with a single strategy (strategic allocation) was crazy. I can only imagine how confusing this is for my client. Perhaps the goal of having so many funds is to confuse the client and lead her to believe that she needs someone to manage her account since she could never choose 31 mutual funds on her own.
What was even crazier about having 31 funds in the account was the overlap of funds. Among the funds, there were 7 large company US funds, 5 small company US funds, 6 international developed markets funds, and 6 bond funds. The question is whether owning more mutual funds in one asset category makes the account better diversified or improves overall performance.
Diversification seeks to reduce unsystematic risk in investments. For example, if you own only one company’s stock in your portfolio, you are exposed to the risk from that specific company, as well as the company’s industry (among other risks). A bad quarterly report by the company can cause a large drop in your portfolio value. By owning many stocks in different industries, the company and industry specific risk can be greatly reduced. A mutual fund typically owns tens or hundreds of stocks, so it is already diversified (at least within its asset category). There really is no need to own 7 different funds in one asset category to be better diversified.
In order to test the performance of the account, I replicated the portfolio allocation using low-cost, exchange-traded funds (ETFs). I chose 8 ETFs from various asset classes to match the allocations in the 31-fund account. Then, I compared the performance of the two portfolios over the last 5 years (based on current holdings). The 8 ETF portfolio had outperformed the 31-fund portfolio by about 1% per year (6% vs 5%). This translated to a cumulative 6.2% outperformance over the 5 years. This excluded any advisory fees for either portfolio.
I presented the results to my client (who gave me permission to use her case in this blog posting). She asked me what accounted for the outperformance, since most of the mutual funds in her 31-fund account were highly rated. One of the biggest sources of outperformance was the cost of the funds in each portfolio. In the ETF portfolio, the average fund expense ratio was 0.14%. In the 31-fund portfolio, the fund expense ratio was 0.93%. The funds being used in the 31-fund account cost significantly more! The difference in annual fund management fees accounted for 79% of the portfolio performance difference.
Accounts with larger values invested typically have more mutual funds or ETFs than smaller accounts. This is often related to trading costs and reinvestment costs. However, 31 funds is an extreme number for even a large account. The only case I can think of where this might make sense is where different investment strategies are combined in the account. Nonetheless, if you have an investment account with so many different investments that it takes multiple pages in your monthly statement to list everything, you might want to have a conversation with your advisor to understand why there are so many different investments. At L Squared Wealth Management, we believe it is important for clients to understand their investments and the rationale for each one. We are happy to provide a complementary portfolio review and second opinion.
Feel free to contact us with any questions at info@L2Wealth.com.
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