Can Too Many Funds Spoil a Good Portfolio?
Chuck Jaffe at Marketwatch says that when it comes to building a mutual fund portfolio, less is usually more. Jaffe's point is that owning more than ten or so funds is at best unnecessary, and at worst can turn your holdings into an overpriced index fund.
With actively managed mutual funds, more is not necessarily better. Studies show that owning four funds in the same asset category is virtually certain to create a 'closet index fund,' which means that the combined performance of the funds winds up doing no better than the index for that asset class
Plus, that index-or-worse overall performance comes at a much higher cost than simply owning a mutual-fund or exchange-traded fund tracking the index.
...Ultimately, an investor can build a winning portfolio with no more than six funds covering domestic and foreign markets, large- and small stocks, bonds and money-markets. Sector funds and other issues can be used to flesh out the holdings and tilt the assets to areas the investor prefers, without creating massive overlap with the core holdings.
A portfolio that's a little more complicated is fine, but going much further -- with closer to 20 funds than a half-dozen, and with too many decisions to make -- is almost sure to leave you with an unmanaged mess."
While it is true that the more funds you own, the closer your portfolio becomes an overpriced index fund, it is also true that 10 cheap good funds are better than five expensive mediocre funds. There is also the risk of over-relying on an expert manager by focusing too much on a few funds - something investors in Bill Miller's Legg Mason Value (LMVTX) are finding out right now. Moreover, it can be impossible to own just a few funds when you consider many investors own funds in several accounts - 401(k)s, IRAs, etc and collectively owning 20 funds is all but unavoidable.
The article also features this dubious advice from a Morningstar exec.:
'It's a good time to check up and see if your fund is performing worse than you would have expected in a tumultuous environment,' said Christine Benz, director of personal finance at investment researcher Morningstar Inc. 'If performance is worse than you expected, then maybe the fund is a bad match for your risk tolerance.'"
But wouldn't such behavior lead to buying high and selling low? Don't most people buy funds after they perform better than expected? In fact isn't that how funds get highly rated in the first place? Weren't all the Janus funds performing better than expected in the late 1990s? By this logic you would have sold them all after they fell harder than expected in 2000-2002, missing the better than expected returns from 2003-2007.
There is nothing wrong with a focused fund portfolio. Our MAXadvisor Powerfund Portfolios newsletter publishes seven model mutual fund portfolios, none of which have held more than ten funds and ETFs. That said, there are cases for smaller allocations to certain more targeted funds that could increase the number of portfolio holdings to more than that.
The Max point about multiple types of accounts is VERY well taken, and obviously Chuck J. isn't taking that fact into "account" when he says six funds can do it all. In our household, we've got my IRAs, my wife's IRAs, her 401k, and taxable accounts. We also favor SRI/ESG investing where reasonably priced options exist, and of course that's not everywhere, so that means more funds in and of itself.
Other points: broad foreign funds, including indexes, for the most part have practically nothing in small and mid-caps (EXWAX is one exception), so you've got to add another fund for that kind of exposure, and without it, what opportunity lost!
And in bonds, there are too few actively managed funds with a broad mandate, so (like with Vanguard) if you want more than an index, it's sector by sector by sector, defined very narrowly.
In the universe of more-focused, active global funds, you can pile up half a dozen and have very little overlap.
Last, there's a huge gulf in the last year-plus between active and index funds; our actively managed funds are making money or staying even, while indexes (only choice in 401k) have been diving. In a sideways or down market, indexes just won't cut it, so there's yet another source of the need to own more funds.
I've often thought that if you've decided to risk some of your funds with active management, it makes a lot of sense to split it across multiple managers (unless the fund is already huge and is internally split) to minimize individual manager risk.
If all the funds are in the same class, say, large cap value, then it hopefully shouldn't end up looking like an index. There will hopefully be overlap where the managers are all seeing the same values, etc.