It’s the mantra among financial advisers: You need a diversified portfolio. To that end, investors hear a lot about the minimum number of mutual funds and ETFs they need to get that diversification.
But is there a maximum amount of funds an investor should hold?
Yes, according to financial experts. At some point, adding funds becomes counterproductive. For some advisers, the number is as low as 10; for others, it’s closer to 20.
“Once you get into the 20s, you’re getting marginal benefits from a diversification standpoint,” says Josh Charlson, a director of manager selection at research firm Morningstar in Chicago.
Indeed, you can become so diversified that you simply mimic a big index, while paying lofty fees. It is also more difficult to track and rebalance a portfolio with many funds. And if you have a lot of mutual funds in a nonretirement account, you may face substantial taxes.
In building a portfolio, investors should first think about how to allocate their assets rather than how many funds to own, experts say. “If you start with that question, it’s easier to get to the right number of funds,” Mr. Charlson says.
For instance, some investors may own six U.S.-stock funds, with a focus on large-cap growth, large-cap value, midcap growth, midcap value, small-cap growth and small-cap value. But if they own more than those six, there is a good chance they will come close to replicating one of the major market indexes. They may also have funds with overlapping holdings. Instead, they could just buy a passive mutual fund or ETF based on the index.
If investors build a portfolio with actively managed funds, they will pay more in fees than if they use passive funds. If they’re using ETFs and trade actively, their trading commissions also may start to add up. The average expense ratio for active U.S. open-end mutual funds is 1.11% a year, and it’s 0.51% for passive ETFs, according to Morningstar.
“You should try to cover much of the market, but try to do it efficiently, without duplication,” says Tom Fredrickson, a financial adviser in New York who’s part of the Garrett Planning Network. “I would think longer about adding a fund than subtracting one,” he says. “You want to make sure it’s really adding diversification.”
Hard to follow
The more funds investors own, the more they have to follow, which can be a burden, especially with actively managed funds. Of course, investors will want to monitor their funds’ performance. They will also want to know if the managers of a fund change or if its strategy changes. And they will want to regularly look at their funds’ holdings.
“[All] that’s hard to track,” says Jack Ablin, chief investment officer of Cresset Wealth Advisors in Chicago. In addition, investors will likely receive a good deal of written material from their funds. “You could be inundated with a lot of pieces of mail or email,” he says. “Unless you’re looking for kindling to start a wood stove, it doesn’t make sense.”
An excess of funds makes it difficult to analyze what is owned and to make sure the asset-allocation weightings are correct. Figuring out how the sale of a fund would affect a portfolio becomes tricky. A bloated fund roster also adds complexity to periodic rebalancing of a portfolio to keep weightings in line.
“Even if you’re rebalancing just once a year, that’s a lot of work,” Mr. Charlson says. “You probably won’t be inclined to do it as often, and your allocation gets out of whack.”
Tax costs also are harder to track in a nonretirement portfolio stuffed with funds. Investors don’t have to pay taxes on income in a retirement fund. But rebalancing a portfolio in a nonretirement account can generate a capital-gains tax liability for the funds that you sell.
Experts say all of these complications necessitate the use of a computerized tracking tool to aggregate and analyze a portfolio that’s stuffed to the gills.
Burden for your spouse
Multiple-fund portfolios generate another issue for older investors.
“If you die, your spouse is left with a huge welter of funds to deal with,” Mr. Fredrickson says. And that may be beyond the spouse’s comfort level, leading either to mistakes in their management of the funds or to high costs from hiring an adviser to manage the portfolio.
Investors will want more funds if they predominantly have actively managed funds, because there is a much greater chance that one of them will blow up than there is of a passive fund blowing up, Mr. Fredrickson says. He generally focuses on passive funds in client portfolios, with a maximum of 12, but says when a client prefers actively managed funds, a case can be made for up to 20 in a portfolio.
Sometimes investors’ fund count can rise unintentionally as they randomly purchase funds that look appealing over time. It even happens to professional investors. Mr. Ablin, for example, manages money for his 22- and 26-year-old daughters. As their savings came into the accounts, “I would buy interesting funds,” he says. That included a Mexican stock fund and currency funds.
The buying brought him up to 16 funds per daughter. Several weeks ago, he sold all the accounts’ losers to offset capital gains. He’s now down to eight funds for each daughter and sees that as an approximate maximum.
“There’s a tendency to buy shiny new funds,” he says. “But that may undermine your mission.”
To avoid adding extraneous funds, Mr. Charlson says, the question to ask when considering a new one is, “What are the allocations I need, and does the manager fit this well?”
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