The Diminishing Returns Of Diversifying

By now, its importance has been drummed into you: Make sure your investment portfolio is suitably diversified, and familiarize yourself with an array of mutual funds, because they're a good way to spread your risk and extend your opportunities. But you may also quite rightly suspect that owning too many mutual funds that share the same investment objective may not be the wisest strategy. For one thing, a motley roster of individually managed funds is expensive to support, when a comparable index fund could do the same job at much lower cost.

So how many mutual funds should you carry within a given investment class? How many growth funds do you need before the benefits of diversification diminish? How many balanced or international funds? In short, how many is enough, and how much is too much?

LESS IS MORE. Money managers have been puzzling over the same questions. To get at the answers, managers at Prudential Diversified Investment Strategies fed a computer with five-year returns from randomly chosen mutual funds in four equity categories--growth, growth and income, international, and balanced funds--and compared the results against benchmark indexes. Their findings are that you probably should own more than one fund in each category but no more than three. "By the time you've got four funds, you're very highly correlated with whatever benchmark you're looking at," says Mark Stumpp, chief investment officer at PDI Strategies. At that point, he says: "You may as well have bought an index fund."

Many Wall Street sages are even more cautious. "You should probably not have much more than two," says Robert Markman of Markman Capital Management in Edina, Minn. Meanwhile, John Bogle, chairman of Vanguard Group, who has made a career out of advising investors not to attempt to beat the market, says those who nonetheless try should stick to one fund of any given type.

Indeed, as you pile on like-minded funds, there's a greater chance that the creative decisions each fund manager makes will cancel the others out. The pros may be the ones bumping heads, but you're the one who is going to feel it. Morningstar Inc. estimates that fees for actively managed equity funds average 1.5% of assets. By contrast, fees for a typical index fund are 0.6%. And Vanguard's equity index fees average just 0.2%.

The best way to mitigate risk and optimize performance is to choose funds that are unrelated to one another. You can consult Morningstar, Value Line Mutual Fund Survey, or a fund's annual report to see how your

holdings stack up. PDI Strategies found, at least statistically, that growth-and-income funds, which tend to be conservative investments, are unlikely to vary over time from the Standard & Poor's 500-stock index. On average, if you own just one growth-and-income fund, you are already, in stat-speak, 94% correlated to the S&P 500. Hold four funds, and the ratio climbs to 97%. Your greatest chance to beat the market--or get hammered, of course--is to invest in funds that bear little statistical relationship to a benchmark


Put another way, even if you're lucky enough to own four very different growth-and-income funds, you would still come close to mimicking the market, experts say. By unloading two or three of those funds, you would get more lift from your portfolio.

Less is also more when compiling a portfolio of growth funds that concentrate on midsize and large U.S. companies. If you own two growth funds that bear little resemblance to one another, you would have a fairly low 65% statistical correlation with the Russell 1000 Growth Stock Index. But if you randomly selected two more growth funds, the relation rises to 81%.

FOREIGN HIT. The story is much the same when you look into overseas funds. If you could select the single international fund with the smallest relationship to Morgan Stanley Capital International's Europe, Australia, and Far East stock index, you're still at the 75% correlation mark. Adding a second fund only makes it more likely that you'll move in lockstep with the market. Moreover, the higher expenses associated with international funds are difficult to overcome, says investment counselor Gary Greenbaum, president of Greenbaum & Associates in Oradell, N.J.

Yet balanced funds and asset-allocation funds, which blend equities, bonds, and cash, show little relationship with an underlying index. Choosing the two most dissimilar funds in this group would give a remote 44% correlation to a benchmark made up of three separate indexes: the S&P 500, the Lehman Brothers Aggregate Bond Index, and three-month U.S. Treasury bills. And if this portfolio added two other wayward funds, the relationship to the index would still be just 64%. One explanation, says Rich Whitney, a vice-president at T. Rowe Price Associates, is that these managers frequently juggle assets around, so their stock and bond selections are less likely to mirror a particular stock or bond index.

Ready to wean yourself away from your fund-collecting habit? Those who have hoarded funds of the same pedigree in the past should also be mindful of the tax consequences when they start to cut back.

BIT BY BIT. Most often, some of a fund's tax hit is taken annually, when capital gains and dividends are distributed to shareholders. If the fund has appreciated and you have been reinvesting distributions in new shares, your average cost-basis will be higher, which will ease the tax on any sale. Another tactic would be to use dollar-cost averaging to get out of a fund by unloading a set number of shares each month. In paring down your portfolio, your tax bite will be less if you drop those high-turnover funds that have been distributing capital gains every year, says Robert Willens, a tax specialist at Lehman Brothers.

Most of all, in trying to figure out how many mutual funds to hang on to, you shouldn't lose sight of your investment objectives, your tolerance for risk, and your sense of whether you think the market is going to head up or down, says Pamela Pearson, a Baldwin (N.Y.) financial planner. That's sound advice, and you can never have too much of that.

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