ETF Investing Guide: So You Thought Mutual Funds Help You Diversify?

The final problem with actively managed mutual funds is that they do a lousy job at what should be their key attraction: diversification. Three factors make it hard to diversify by using actively managed mutual funds:

• Mutual fund investors tend to buy too many funds, and this leads to investors owning funds with overlapping positions. (Perhaps that’s exacerbated by the fact that mutual funds don’t publish their holdings in real-time.) How many people own a large cap growth stock fund and a tech fund? Too many, given the huge overlap between the two categories. You think you’re diversifying by owning funds in different categories, but in fact the holdings of the funds overlap, perhaps significantly. Even a tech fund and a diversified stock fund may have considerable overlaps in individual stocks.
• Fund managers often stray from their stated style, or have unconventional interpretations of their style. Take the Legg Mason Value Trust as an example: as of June 30, 2003, it held 7.65% of its portfolio in Amazon.com and 5.36% in Interactive Corp. Now, I’m not arguing that these two Internet companies were not good value at the time. But I would argue that a common (though perhaps superficial) definition of “value”, perhaps based on P/E ratios or price-to-book ratios, would exclude those stocks. So investors with “diversified” portfolios of mutual funds including The Legg Mason Value Trust as a “value fund” and a tech fund as a “growth fund” could find themselves with over 10% of their portfolios in Amazon.com and Interactive Corp. And this is a good case: Bill Miller, who runs the Legg Mason Value Trust, has been consistent in his unconventional approach to “value”. The problem with many other funds is that managers change their styles or simply breach their funds’ style guidelines while attempting to buy stocks that “are working”.
• Fund managers too often try to time the market by varying their funds’ cash positions. Most mutual funds keep some percentage of their assets in cash; it helps them to handle investor redemptions without having to sell stocks. But they have considerable discretion about how much to keep in cash. Many fund managers try to time the market by increasing their cash position when they expect the stock market to fall, and reducing their cash position when they expect stocks to rise. But this makes it impossible for investors to manage their own asset allocation between stocks, bonds and cash, since the proportion of your assets that you think you’ve dedicated to stock funds in fact contains a percentage of cash.

Many investors concerned about diversification buy quite a few mutual funds. That can lead to more effective diversification. The average mutual fund, according to Morningstar, holds about 200 stocks. As the number of funds you own increases, the aggregate effect is that your portfolio starts to mimic the overall US stock market. Well, that’s certainly diversified.

The downside of buying a basket of mutual funds is that actively managed funds charge higher fees than the cheapest total market index fund, they incurr trading costs to buy and sell stocks, and you’ll still hold an unspecified portion of your assets in cash in those funds (and paying steep fees on “management” of the cash). So what you end up with is a collection of funds that mimic an index fund, but with higher expenses and larger holdings of low-interest-earning cash.

In conclusion, actively managed mutual funds are a poor option for investors. They underperform the market. Investors who pick them using Morningstar ratings are using backward-looking criteria with no predictive value. Moving between funds based on changing ratings can lead to excessive tax bills, and dramatic increases in fees if the funds charge “loads”. And finally, actively managed funds make diversification difficult, when that was supposed to be their key attraction.

So if you shouldn't pick stocks or buy mutual funds for your core portfolio, what should you do? That's what we'll discuss in the next part of this guide, "A Better Approach".

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