Over Diversification Foils Mutual Fund Collectors

Investors who “collect” a large number of mutual funds seek to increase returns by diversifying their portfolio, but investors with numerous funds are more likely to lower their returns through over diversification and mutual fund overlap.

A significant share of investors appear to be at risk of over diversification, according to the latest monthly survey from Millionaire Corner. More than 35 percent of Millionaires surveyed in January own 10 to 25 mutual funds and more than 9 percent own 25 or more. That’s way above the eight to 10 mutual funds recommended by the American Association of Individual Investors or AAII, a nonprofit association dedicated to investment education.

“Is your portfolio of mutual funds cluttered just like your closet? Have you owned some mutual funds so long that you have forgotten why you bought them?” ask the AAII. “Are there some mutual funds on the top shelf, way in the back of your financial closet you haven’t even looked at in a while?”

A cluttered portfolio of mutual funds may not provide investors the diversification they seek in a pooled investment such as a mutual fund or ETF. Such funds can offer exposure to a large number of companies or bonds, enabling an investor to spread risk over a large number of products without having to manage multiple investments. The advantages of pooled investments can be diminished when an investor purchases mutual funds with overlapping investments. Mutual fund overlap can overweight a portfolio by concentrating assets in one company or market sector. Over diversification occurs when an investor purchases so many overlapping funds that they essentially cover an entire sector, causing assets to move up and down with the index.

“If you hold several funds that all use similar investment strategies in your portfolio, you essentially hold the market. You could achieve the same result much more cost-effectively by simply buying an index fund,” according to the website AXA, published by the AXA Equitable Life Insurance Co.

“You need to understand what your mutual funds are investing in so that you can be fully diversified,” says Hank Coleman, founder of Money Q&A. “You do not want all of the mutual funds you invest in to react to changes in the market or economy the same way. You want some of your investments to zig when others zag.”

The Internet offers investors many tools for evaluating mutual funds and preventing mutual fund overlap, says Coleman, who recommends the Yahoo finance fund screener and the Portfolio X-ray tool offered by Morningstar.

Investors who own more than 10 or so funds may find it burdensome to track the performance and asset allocation of such a large number of holdings, said Maria Crawford Scott, editor of the AAII Journal. Crawford recommends careful selection of one fund in each of the following major asset classes – large-cap, mid-cap and small-cap U.S. stocks, a large-cap European fund, and funds investing in emerging markets in Latin America and the Pacific Rim. Crawford also advises one or two bond funds, depending on an investor’s goals and tax status, and a money-market fund. Staying within these guidelines can help investors avoid the pitfalls of mutual fund overlap and over diversification.