How Many Mutual Funds Should You Have in Your Investment Portfolio?
by John Markese
Adding a new fund to your portfolio is far easier than reorganizing your fund portfolio and discarding inappropriate, redundant, or simply poor-performing funds. The answer to the question of how many mutual funds you should have in your portfolio is not just a number. But if you have many more than eight mutual funds in your closet, chances are you need to do some serious portfolio cleaning. Here's why.
First, in order to be well-diversified, your mutual fund portfolio should be invested in domestic and foreign stock mutual funds and in fixed-income funds or income fund equivalents. Within the domestic stock market, your funds should cover large stocks, small stocks, and stocks in-between.
Foreign investments should cover established firms in industrialized countries and stocks of countries that would be considered emerging markets. While geographic diversification domestically is relatively unimportant, diversification by region for foreign investments is. Representation in Europe for a large stock international fund is important and investments in Latin America and the Pacific Rim are crucial for an emerging stock fund. Global funds that invest domestically and abroad sound like a one-fund answer, but it is too much geography for one portfolio manager to cover and global funds tend to change domestic/foreign portfolio weights as world conditions change, neutralizing some diversification benefits.
Let's stop and take a count: one large stock domestic fund, one small stock domestic fund, one international large stock fund, one emerging market stock fund—so far, four funds. Have we missed the mid-sized domestic stocks? Well, check your large-cap stock fund and your small-cap stock fund to see what they include. Usually, large stock funds leak down into the mid-size range and small stock funds push up into the mid-size range. If not, add a mid-size fund to avoid any portfolio gaps. Now we may be up to five, all of which are stock funds at this point.
If you want income and the diversification benefit of a fixed-income fund, then a simple choice would be an intermediate U.S. government bond fund. The intermediate maturity—in other words, a three- to 10-year weighted average maturity for the bonds in the portfolio—captures most of the yield of longer term funds with much less volatility when interest rates change. If you are in a high federal tax bracket, a municipal bond fund might be a better choice. And if you live in a state with high state and local taxes such as California or New York, you may want to consider substituting a state-specific municipal bond fund to minimize federal, state and local taxes on the bond income. Aggressive investors can reach to high-yield corporate bond funds and if they are in a high tax bracket, hold the fund in a tax-sheltered account. While high-yield (junk) bond funds invest in lower-quality corporate debt that pays high income, the individual default risk of the bonds in the portfolio is softened through diversification and the high income dampens portfolio volatility. Furthermore, high-yield bonds tend to be sensitive to the economic cycle, acting more like stocks than government bonds.
One bond fund in a portfolio may make sense, but it is difficult to imagine the value of more than two bond funds. For high-tax bracket individuals, a municipal bond fund and perhaps a high-yield bond fund in a retirement account may make sense, but high-tax bracket investors often prefer growth through common stock funds rather than income from any source.
So, if we add one to our fund count for a fixed-income fund we have a total of six; two bond funds would push it to seven.
What about all those other fund categories? Do you need a gold fund, mortgage-backed bond fund, international bond fund, sector fund, index fund?
Let's take them one at a time.
- Gold funds are concentrated sector funds holding gold mining stocks primarily in North America, South Africa, and Australia. They are extremely volatile, as gold price changes are magnified by the operating cost breakeven points of gold mining firms. Do you need a gold fund in your portfolio? No. Most investors use gold funds as a store of value, a hedge against inflation. Over the last decade, however, they have been neither. When stocks are roaring up, you would like your gold fund to behave like a stock, but it tends to act like gold bullion. When the stock market collapses, you hope your gold fund behaves like gold bullion, but unfortunately, it tends to act more like a stock.
- Should you consider adding a mortgage-backed bond fund to your portfolio? Probably not. A diversified portfolio of mortgages that promise higher returns than a U.S. government bond portfolio of similar maturity does have some appeal. However, mortgage-backed funds have at times behaved as badly as gold funds. When interest rates rise, bond prices fall and bond mutual fund shares also fall in price. So, as an investor, when rates rise, you want a mortgage-backed bond fund to act contrary to a bond, but it doesn't. When interest rates fall, bond prices and bond mutual fund prices rise, but a mortgage-backed bond fund will respond more to the mortgage market. When mortgage rates fall along with interest rates, mortgages are refinanced and part of your investment is essentially handed back to you to be reinvested at lower rates.
- International bond funds often promise higher yields, but the difference in yields is usually due to differences in currency strength. A country with high interest rates is likely to be protecting a weak currency. When rates are high, investors buy the currency to buy the bonds and support the currency in the process. If the currency in which the foreign bonds are denominated weakens, the differences in yield may evaporate or even fall below domestic yields. Currency speculation is not a game most investors should play.
- Sector funds concentrate on one industry or a few closely related industries. Because they are concentrated in an industry, they are not well diversified. Beyond the additional risk, the trick to master is just which sector funds to invest in. At the top of most "best-performing funds" lists will be some sector funds, but they'll also appear on the "worst-performing funds" lists—it's just a question of when. Most aggressively managed stock mutual funds concentrate in some industries and might be viewed as a combination of sector funds. Few investors are willing and able to place sector bets unless they have particular experience in a sector through their education, work experience or vocation, and if they do have expertise, selecting individual stocks may be more rewarding.
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- Do index funds have a place in your portfolio? Yes, but they don't add to the number of funds. They simply are another way of managing your assets in one of the fund categories necessary for a rational, well-diversified, non-redundant fund portfolio. An index fund should be employed in a situation where even the brightest and best of portfolio managers using superior timing and stock selection decisions would have difficulty overcoming the cost advantage of an index fund. Areas of the markets that are efficient, have readily available information, are well-researched and followed closely by the investment community, or are simply not susceptible to very profitable analysis are candidates for indexing. The market for large domestic stocks and the U.S. government bond market fit the index fund criteria. Small domestic stocks and emerging foreign markets do not. These markets have attributes that make intelligent, thorough analysis more likely to contribute returns that can overcome the cost of active fund management.
An added classification for domestic stock funds is investment style—funds can be categorized as growth or value, or both. Growth funds would typically invest in stocks with high earnings growth expectations; value funds would invest in stocks with low prices relative to earnings and net asset values. The style label should be based not on what the fund says it is or what it says it will do, but on what it does. Investment style classification should serve to help investors avoid redundancies and coverage gaps. But they also beg the question, "Should a portfolio of stock funds be diversified by style as well as size of stocks?" Size, yes. Style, perhaps.
Many funds operate in more than one stock size range and many use approaches that are classified as both growth and value. Do you need a value and growth fund in each stock size category? No. One value fund, and it might be the large stock fund, and one growth fund covering the mid-sized and small stock area provide coverage of size and style. A large stock index fund will be both growth and value, and more extensive indexes will cover value and growth for more stocks and stock size ranges.
Understanding fund style and stock size characteristics will help prevent duplications and unnecessary run-up in fund count. Now, back to our fund count: We left off at six with one fixed-income fund, or seven funds with two fixed-income funds. Add a money market fund and the counter clicks to eight. Be sure you can justify adding funds to your portfolio beyond eight. Make certain you need them, that they truly cover new ground in asset type, geography, or investment style, and that the addition is meaningful.
Taking the time to create an organized, understandable, appropriate and efficient portfolio of mutual funds may be your most important investment.