The Risks of Mutual Fund Overdiversification

Diversification is an important part of investing for retirement. But what does it mean to be diversified in your investments? In a nutshell, it means spreading out risk so each part of your portfolio isn’t overly vulnerable to one market or sector. You allocate each asset class you own across many parts of the market to reduce volatility risk.

The premise of diversification is if one company or sector goes down and takes your assets with it, the other holdings will not be as impacted. In other words, “don’t put all of your eggs in one basket.”

There are various methods to craft a diversification strategy, but all must start with the right asset allocation, a fancy term to describe which types of securities and assets you have in your portfolio to balance potential risk and return. It goes without saying that asset allocation should be individualized to specifically match factors personal to you, such as your longer-term financial goals and investment time horizon.

Mutual funds can provide an easy and cost-effective way to achieve broad portfolio diversification. Yet each fund executes its own strategy. It interprets the markets from a particular standpoint and bases its broad investment strategy and corresponding asset allocation on that distinct interpretation.

But owning mutual funds doesn’t necessarily mean you get the right level of diversification. Although some investors might think more mutual funds in a portfolio means more diversification—and that more diversification is automatically better—investing in several funds can potentially expose your portfolio and retirement goals to unforeseen financial risks.

In the following section we’ll discuss the risks of overdiversification, so you can help prevent it from impacting your portfolio.

The Importance of Diversification in Retirement

A diversified portfolio holds assets with exposure to different parts of the market. These markets have varying degrees of correlation to one another. In other words, some markets move similarly while others won’t. So if an investor has exposure to two markets that are “negatively correlated,” that means if one market underperforms, ideally, other markets may hold steady or even rise.

What might happen if you aren’t diversified? Suppose the bulk of your retirement portfolio is allocated toward inflation-sensitive stocks. If interest rates rise, the value of your stock holdings can decline, reducing the value of your entire portfolio. Had you invested in other less-correlated assets, including securities not sensitive to inflation, your portfolio might have avoided the much of the unrealized losses.

But diversification’s benefits also have their limits. In other words, there is a certain point beyond which an investor’s portfolio can be overdiversified, where investing in additional securities can become counterproductive.

Hidden Risks of Overdiversification

It may seem a bit simplistic to say that too much of a good thing can lead to bad consequences, or that more doesn’t necessarily mean better. But this is a common challenge some investors with large retirement portfolios have to face.

Potentially higher transaction costs. Excessive diversification can mean you have to pay more for transactions across all your holdings. For instance, if you own 10 mutual funds, and each mutual fund holds 300 stocks, you may hold as many as 3,000 stocks without realizing it. As those stocks are bought and sold within a portfolio, the funds’ investors ultimately bear the implicit and explicit transaction costs.

Inability to outperform (or even perform as well as) the market. It almost goes without saying: If you own the entire market, or close to it, you can’t expect to outperform it. Also, if you effectively own the market through several mutual fund holdings, you’re almost certain to underperform it, given the expenses you incur to own the funds.

Paying multiple fees and expense ratios. Most investors are aware of the varying management fees associated with mutual funds. But not all investors know about the additional costs—administrative fees, marketing fees, transaction costs and other operating costs—that are also part of the package. If you pay attention to the average “expense ratio,” or average costs a fund must cover to operate, you can see the extent to which these additional fees erode your principal. The figure below from Morningstar illustrates the median costs of mutual funds by category.*

Median Annual Costs of Mutual Funds by Category

Holding several mutual funds in your retirement account can make it more difficult to know how much you are actually paying for your investment management—an important point for any investor to know.

Overconcentration due to replication of stock holdings. Many mutual fund investors own more than one mutual fund, but these funds may have overlapping holdings. Suppose you own two or three mutual funds with holdings in the US tech sector, and perhaps even the same stocks. This means your entire portfolio may be overconcentrated in that sector and the handful of stocks each fund holds. By owning multiple funds for the purpose of having a well-diversified portfolio, you may end up achieving the opposite of your goal.

Conflicting decisions between fund managers. Let’s suppose you own two mutual funds run by different managers. In one fund, the manager decides to buy equity holdings of Country A as she feels those assets may perform well. Meanwhile, in the other fund, the manager decides to sell Country A’s equity holdings because he believes those assets will perform poorly. You end up paying transaction costs for disjointed decisions that ultimately may have no net effect on your portfolio.

The Takeaway: If you hold multiple mutual funds, you may inadvertently be increasing your risk—not reducing it.

A More Efficient Solution

Mutual funds can still have diversification benefits making them suitable for some investors with smaller portfolios, because holding a broad-based mutual fund or sector-specific index fund can be more cost effective than building a diversified portfolio through outright stock ownership. But we believe these benefits don’t apply to every investor—and mutual funds aren’t a universal solution to attain diversification in a retirement portfolio.

In light of the fees and risks associated with mutual funds, high net worth investors may find it more beneficial to invest directly in stocks or bonds.

Diversifying your portfolio through direct stock purchases can help:

  • Reduce the costs and tax inefficiencies associated with fund turnovers, management fees, expense ratio costs passed to the investor, and taxes for capital gains you may never have received
  • Reduce the risks of replicated stock allocations, overconcentration in a given market or sector, and exposure to conflicting investment strategies between fund managers

Most importantly, direct stock market investments allow high net worth investors to diversify their portfolio in a manner that is more transparent, customizable and cost effective.

Fisher Investments provides the expert research and analysis you need to have confidence when investing for retirement. Contact us for a portfolio evaluation and learn more about how we can provide a solution tailored to your needs, or download our guide on the 5 Pitfalls of Mutual Funds for more information.

*Source: Morningstar, as of 12/2/2016.