Diversifying Mutual Fund Portfolios: Benefits Of Multiple Fund Families

Investing in mutual funds is a popular option for those looking to diversify their portfolio and spread risk. But is it beneficial to invest in multiple mutual fund families? The answer depends on several factors, including your financial goals, risk tolerance, and investment strategy. Diversification is a key principle in investing, and it applies not only across different asset classes but also within the same asset class. This means that investing in multiple mutual fund families can provide exposure to a wider range of companies, industries, and investment strategies. However, it's important to remember that over-diversification can dilute potential gains and lead to higher fees.

Diversification of investments

Diversification is a risk management strategy that mixes a variety of investments within a portfolio. The aim is to limit exposure to any single type of asset and reduce volatility over time. The rationale is that a portfolio of different asset types will yield higher long-term returns and lower the risk of any individual holding.

Diversification is most often achieved by investing in different asset classes such as stocks, bonds, real estate, or cryptocurrency. It can also be achieved by purchasing investments in different countries, industries, company sizes, or term lengths for income-generating investments.

For example, stocks are the most aggressive portion of a portfolio and provide the opportunity for higher growth over the long term. However, this greater potential for growth carries greater risk, especially in the short term. Most bonds, on the other hand, provide regular interest income and are generally considered less volatile than stocks. They can also act as a cushion against unpredictable stock market behaviour.

There are other benefits to diversification. It may be more enjoyable for investors to research new investments, and it increases the chance of hitting positive news. Instead of hoping for favourable news about one company, investors can benefit from positive news about one of many companies.

However, diversification can also be time-consuming and incur more transaction fees and brokerage commissions. It also limits short-term gains. If one stock in a portfolio of six doubles in value, it won't have as much impact as if the entire portfolio had been invested in that one company.

The consensus is that a well-balanced portfolio with approximately 20 to 30 stocks diversifies away the maximum amount of unsystematic risk. However, there is no magical "right" number of mutual funds for a portfolio.

Mutual funds are a popular way to diversify. Even many mutual fund companies are now promoting life-cycle funds, which consist of a mutual fund that invests in multiple underlying funds. The concept is simple: pick one life-cycle fund, put all your money into it, and forget about it until retirement age.

Risk and return

When considering investing in mutual funds, it's important to understand the relationship between risk and return. Here are some key points to consider:

• Risk and Return Trade-off: Risk and return are directly proportional. This means that higher potential returns are typically accompanied by higher risk, while lower-risk investments tend to offer more modest returns. It's essential to evaluate your risk tolerance and investment goals when deciding where to invest.
• Diversification: One of the primary benefits of mutual funds is diversification. By pooling money from multiple investors and investing in a variety of securities, mutual funds reduce the risk associated with investing in a single company or industry. This diversification helps to minimise potential losses. However, over-diversification is also possible, which can prevent you from making significant gains.
• Types of Mutual Funds and Risk: Different types of mutual funds carry varying levels of risk and potential returns. For example, stock (equity) mutual funds offer higher potential returns but also come with higher risk. On the other hand, bond mutual funds provide more stable returns but with lower risk. Money market mutual funds are considered one of the safest investments, offering low returns with minimal risk.
• Fees and Expenses: Mutual funds come with various fees and expenses that can impact your returns. These include management fees, expense ratios, sales loads, and transaction fees. It's crucial to carefully review and understand these fees before investing. High fees can eat into your returns over time.
• Active vs. Passive Management: Actively managed funds, where professionals actively research and select investments, tend to have higher fees. However, they don't always outperform passively managed funds (index funds), which aim to track a benchmark index. Passively managed funds generally have lower fees and can provide more stable returns.
• Time Horizon: The length of your investment also affects risk and return. Short-term investments are more susceptible to market fluctuations, while longer investment horizons allow more time to ride out the peaks and valleys of the market. A general rule of thumb is to hold mutual funds for at least five years to mitigate the impact of sales charges and short-term market volatility.
• Performance and Consistency: Chasing high-performing funds based on their recent returns is not always a wise strategy. Instead, look for funds with consistent returns over longer periods (3, 5, and 10 years). Consistency is a better indicator of a well-managed fund than short-term gains.
• Personalised Advice: Consider seeking advice from a financial professional who can help you construct a portfolio that aligns with your risk tolerance, investment goals, and time horizon. They can provide guidance on the appropriate mix of mutual funds and other investments to meet your specific needs.

Types of mutual funds

There are many types of mutual funds, and they can be distinguished by their investment objectives, investment approach, and the types of securities they invest in. Here are some of the most common types:

• Stock or Equity Mutual Funds: These funds invest principally in equity or stocks. They can be categorized by the size of the companies they invest in (small-cap, mid-cap, or large-cap) or their investment approach (aggressive growth, income-oriented, or value). Equity funds may also be categorized by whether they invest in domestic or foreign stocks.
• Bond Mutual Funds: These funds invest in bonds and other fixed-income securities. They focus on investments that pay a set rate of return, such as government bonds, corporate bonds, and other debt instruments. Bond funds can vary depending on the types of bonds they invest in and when they invest.
• Money Market Mutual Funds: These funds invest in safe, short-term debt instruments, such as U.S. Treasury bills. They offer low risk and modest returns, typically slightly higher than a regular savings account. Money market funds are often used as a temporary holding place for cash.
• Target-Date or Lifecycle Mutual Funds: These funds automatically adjust their asset allocation over time as investors approach their target retirement date. They typically shift from a higher percentage of growth funds to a higher percentage of income-oriented funds as the target date nears.
• Index Mutual Funds: These funds aim to replicate the performance of a specific stock market index, such as the S&P 500 or the Dow Jones Industrial Average (DJIA). They are passively managed and tend to have lower fees than actively managed funds.
• Balanced or Asset Allocation Mutual Funds: These funds invest across different types of securities, such as stocks, bonds, money market instruments, or alternative investments. Their objective is to reduce risk through diversification.
• Income Mutual Funds: These funds focus on providing a steady stream of income, typically through investments in government and high-quality corporate debt. They hold these bonds until maturity to provide consistent interest income.
• International or Foreign Mutual Funds: These funds invest only in assets located outside of the investor's home country.
• Regional Mutual Funds: These funds focus on a specific geographic region, such as a country, continent, or group of countries with similar economic characteristics. They invest in securities of companies headquartered or generating significant revenue within the targeted region.
• Sector and Theme Mutual Funds: Sector funds aim to profit from the performance of specific sectors of the economy, such as finance, technology, or healthcare. Theme funds cut across sectors, investing in companies that align with a particular theme, such as AI.
• Socially Responsible or Ethical Mutual Funds: These funds invest only in companies and sectors that meet certain criteria, such as environmental, social, or governance (ESG) standards. For example, some ethical funds avoid investing in industries like tobacco, alcohol, or weapons.

When deciding how many mutual funds to invest in, it's important to consider the potential benefits of diversification and the potential drawbacks of over-diversification. While diversifying your investments can help spread risk, investing in too many mutual funds may dilute your returns and prevent you from making significant gains. Therefore, it's essential to carefully research and select a diverse range of mutual funds that align with your investment goals, risk tolerance, and time horizon.

Number of funds

There is no consensus on the ideal number of mutual funds to invest in. The consensus is that a well-balanced portfolio with approximately 20 to 30 stocks diversifies away the maximum amount of unsystematic risk. However, a single mutual fund often contains five times that number of stocks, so one fund may be enough.

Proponents of investing in multiple funds suggest that a single fund would fail to provide adequate exposure to international investments. They argue for a global fund, a large-cap domestic fund, a small-cap domestic fund, and an international fund, with perhaps two at most covering the international front. This would bring the total number of funds to six.

On the other hand, investing in too many funds can create an expensive index fund. This is because having too many funds negates the impact that any single fund can have on performance, while the expense ratios of multiple funds generally add up to a greater-than-average number. As a result, expense ratios rise while performance is often mediocre.

While there is no "right" number of mutual funds for your portfolio, most professionals agree that there is no need for dozens of holdings. In fact, even many mutual fund companies are now promoting life-cycle funds, which consist of a mutual fund that invests in multiple underlying funds. The concept is simple: pick one life-cycle fund, put all of your money into it, and forget about it until you reach retirement age.

If you prefer to build a portfolio rather than buy an all-in-one solution, you can take steps to limit the number of funds in your portfolio. First, consider your objectives. If income is your primary goal, an international fund may not be necessary. If capital preservation is your objective, a small-cap fund may not be needed.

Next, compare the underlying holdings of the funds you are considering. If two or more funds have significant overlap in holdings, some of them can be eliminated. There is no point in having multiple funds that hold the same underlying stocks.

Then, look at the expense ratios. When two funds have similar holdings, go with the less expensive choice and eliminate the other fund. Every penny saved on fees is one more penny working for you.

Finally, if you are working with an existing portfolio rather than building one from scratch, eliminate funds that have balances that are too small to make an impact on overall portfolio performance. If you've got three large-cap funds, for example, move the money to a single fund. The amount spent on management-related expenses is likely to decrease, and your level of diversification will remain the same.

As a general rule of thumb, you can consider investing in:

• Large Cap Mutual Funds: Up to 2, or 3 at most. Beyond that, there will likely be a significant overlap in the shares owned by your mutual funds.
• Mid Cap Mutual Funds: Up to 2. While you might get higher returns, you also expose yourself to higher risk.
• Small Cap Mutual Funds: Up to 2. Given the high risk associated with these mutual funds, it is best to limit yourself to a small number of small-cap mutual funds and avoid putting a large percentage of your total mutual fund investment into this category.
• Debt Funds: Ideally 1, but 2 is also good. Most debt mutual funds offer similar returns, so it doesn't make sense to own multiple debt mutual funds.
• Sectoral Mutual Funds: Invest in as many of these as the number of industries you have good knowledge about. You should skip investing in these if you don't have a very good idea of the sector the mutual fund is investing in.

Overall, about 8 (or +/- 2) mutual funds seem like a reasonable number to own. However, there is nothing wrong with owning significantly more or fewer mutual funds, provided your decision is well-informed. The number of funds you invest in should depend on your risk profile and investment objectives.

Review and rebalance

When it comes to investing in mutual funds, diversification is key. By spreading your investments across a variety of funds, you can reduce the risk of losing money if one company or industry performs poorly. However, it is possible to over-diversify, which can prevent you from making strong gains.

So, how often should you review and rebalance your portfolio? Well, there is no one-size-fits-all answer, but generally, it's a good idea to monitor your investments regularly and make adjustments as needed. Here are some strategies and factors to consider:

• Calendar-based rebalancing: This strategy involves reviewing your portfolio at set intervals, such as monthly, quarterly, or annually. For example, you might choose to review your investments every quarter and make adjustments if needed. This approach is simple, but it may lead to more frequent rebalancing than necessary.
• Threshold-based rebalancing: This approach triggers a rebalancing action when your portfolio's asset allocation deviates by a certain threshold, such as 5%. For example, if your target allocation is 70% stocks and 30% bonds, you would rebalance when your portfolio reaches 75% stocks and 25% bonds. This strategy requires regular monitoring and may result in frequent rebalancing during volatile market periods.
• Combination of calendar and threshold-based rebalancing: This strategy combines the two previous approaches. It involves reviewing your portfolio at set intervals and making adjustments if the asset allocation has deviated by a certain threshold. For instance, you might review your portfolio annually and rebalance if the allocation is off by more than 5%.
• Investment goals and risk tolerance: Your investment goals and risk tolerance should be central to your review and rebalancing process. For example, if your goal is approaching and your investment time horizon is shortening, you may need to adjust your asset allocation to reduce risk. Similarly, if your risk tolerance changes, you should adjust your portfolio accordingly.
• Tax implications: When selling assets to rebalance your portfolio, consider any tax implications. For example, you might want to consult a tax professional to understand the short- or long-term capital gains taxes that may apply. Alternatively, you can rebalance by redirecting new contributions to underweighted holdings, minimising potential tax liabilities.
• Performance and market fluctuations: Keep an eye on the performance of your investments and the overall market. If certain investments are consistently underperforming or market conditions change, it may be wise to adjust your portfolio. Regular reviews help ensure your investments remain aligned with your goals.
• Number of mutual funds: While diversification is important, having too many mutual funds can dilute the impact of any single fund on your portfolio's performance. It's generally recommended to hold a few mutual funds from most industries, with a total of around 8 funds being a reasonable starting point. However, this may vary depending on your expertise and specific circumstances.

Remember, there is no one-size-fits-all approach to reviewing and rebalancing your portfolio. The optimal strategy depends on your investment goals, risk tolerance, time horizon, and other factors. It's always a good idea to consult with a financial advisor or expert to determine the best course of action for your unique situation.

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