Time to take an inventory of your mutual funds. How many are there? What are their investment styles? Is your portfolio of mutual funds cluttered just like your closet? Have you owned some mutual funds so long that you have forgotten why you bought them? Are there some mutual funds on the top shelf, way in the back of your financial closet you haven't even looked at in a while?
Adding new mutual funds to your portfolio is far easier than reorganizing your fund portfolio and discarding inappropriate, redundant, or simply poor-performing mutual 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 mutual funds or income fund equivalents. Within the domestic stock market, your mutual 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 large stock international mutual funds is important, and investments in Latin America and the Pacific Rim are crucial when considering emerging stock mutual funds. Global mutual 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 diversi
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 mutual 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 mutual fund to avoid any portfolio gaps. Now we may be up to five, all of which are stock mutual funds at this point.
If you want income and the diversification benefit of a fixed-income fund, then a simple choice would be to consider intermediate U.S. government bond mutual funds. 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 mutual 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 mutual fund in a portfolio may make sense, but it is difficult to imagine the value of more than two bond mutual 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 mutual 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 mutual funds; two bond funds would
What about all those other categories of mutual funds? 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.
An added classification for domestic stock funds is investment style—mutual funds can be categorized as growth or value, or both. Growth mutual funds would typically invest in stocks with high earnings growth expectations; value mutual 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 mutual funds be diversified by style as well as size of stocks?" Size, yes. Style, perhaps.
Many mutual 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 the style and stock size characteristics of mutual funds will help prevent duplications and unnecessary run-up in the number of mutual funds in your portfolio. Now, back to our count of mutual funds: 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 mutual 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.