Investing in mutual funds well is not very complicated – a professional investor could actually help you sort out which funds to invest in over a cup of coffee. The mutual fund investing landscape has become apparently complicated, though, because the pretense of complexity is a very convenient way to justify commissions and fees. Many model portfolios of mutual funds we see contain ten to 20 funds, of varying asset classes. Another phenomenon we witness is 401(k)s with 5% or 10% allocated to each of 10 or 20 funds. The first principle of mitigating mutual fund complexity is this: you don’t need more than 3-5 funds in total. Mutual funds are themselves diversified – investing in a dozen funds will at best leave you over-diversified, to the point where it would be far more cost effective to use an index fund. At worst – and we see this routinely – several of those funds will contain the same holdings. Why own Apple in four funds? And would it make sense for one of your managers to be selling Apple in one of your funds while another is buying Apple in a second fund?
The most important risk / return factor for any portfolio is its asset allocation. But there’s no need to get carried away with asset classes. There are really only two, truly distinct asset classes: financial assets (e.g., stocks & bonds) and real assets (e.g., commodities, collectibles, and real estate). For reasons that are too detailed to get into here, we do not recommend commodity mutual funds. Mutual funds of Real Estate Investment Trusts (“REITs”) may be a suitable alternative to some equity funds. The second principle of managing complexity is this: choose a short-intermediate bond fund for your fixed income allocation, and divide your equity allocation among a large cap fund, a small cap fund, and an international fund. Don’t worry as much about how much to put in each of the equity fund types. The main consideration is determining your allocation to fixed income. Keep this simple too: the more nervous investing makes you, the higher percent you should allocate to your bond fund. As well, the longer your investment time horizon, the less you should allocate to bonds.
A final piece of guidance for managing mutual fund complexity: disregard the myriad statistical risk & return measures offered on mutual fund rating services like Morningstar. Beta, Alpha, Treynor Measure, Sharpe Ratio, Sortino Ratio, Standard Deviation – skip right past these data points and move on. Truly, with the exception of Beta and Alpha, most advisors don’t know what they mean or how to calculate them, and the ones who do can’t give a coherent rationale for why you – or anybody – needs to rely on them. More significant still: they’re just not determinative of real investment risk. These are perhaps the clearest example of the pretense of complexity being used to justify high costs.
Next week we will explore why maintaining control of an investment portfolio is important, and what individuals can do to increase their chances that their investments work the way they need them to.