The Problem With Mutual Funds

By: David LeNeveu, Founding Partner Rockmoore Wealth Management [1]

If you are like the majority of investors in Canada, your portfolio of investments in your RRSPs, TFSAs, and other accounts likely hold a number of mutual funds as picked by yourself, suggested by a friend, or recommended to you by an advisor.

Likely, you have been told that by having different mutual funds, you are well diversified and have not given it another thought (other than to make sure they are performing).

While it is true that as an investor, you need to hold a number of different stocks (equities) to be properly diversified, the question very few think to ask is, “Can I be over-diversified?”

The quick answer, YES! To begin, we need to remember that the idea behind diversification, simply put, is to reduce risk while maximizing return. At its core, this is a very simple concept. Academically speaking, a portfolio of just 32 stocks will reduce the overall specific risk (non-systematic) of a portfolio by 95%. By adding another stock, you are no longer achieving any more significant reduction in risk. [2]

You may actually now be suffering from “diworsification.”

This term was coined by Peter Lynch, a legendary fund manager who published the book, One Up on Wall Street. He wrote that “a business (or portfolio) that diversifies too widely risks destroying itself because management time, energy, and resources are diverted from the original investment.”[3]

So why then, would your typical mutual fund hold well over 32 stocks? Unfortunately, it may be because mutual fund managers are looking out for their own best interest, instead of yours. Mutual fund managers’ jobs and paycheques depend on their performance as compared to a benchmark index and/or to each other. If a mutual fund manager can achieve a return that is close to the benchmark, they can reasonably feel secure and justify their job and paycheque. This structure encourages and enables mutual fund managers to simply pick enough equities to closely mirror the benchmark they are being compared to (a term called closet indexing). [4]

This brings us back to our typical Canadian investor. If a typical mutual fund holds an average portfolio of 90 stocks and you hold even just 3 or 4 mutual funds, you likely have a portfolio that holds well over 200 different stocks.

You have now just fundamentally bought a benchmark or index fund. After fees and taxes that are passed from the fund to the investor, our outcome is, inevitably, underperformance.

This is further compounded when our investor finally does decide to move to another advisor (independent or the bank) because of poor performance, relationship, trust, fees, etc. The new advisor will now usually suggest three, four, or more different mutual funds.

Unfortunately, this essentially gives the investor an almost identical overall underlying investment. The investor feels positive about making a change, but very little change has actually occurred.

Ultimately, there is no point in paying the cost of a mutual fund manager and all of the embedded fees when you can simply and cheaply buy essentially the same thing with a passively held index or benchmark ETF (Exchange Traded Fund).

Don’t get me wrong; I am not saying that you should just go buy a passively invested index ETF (though in some cases it is the right answer). I am a believer, proponent, and investor of a fully discretionary, actively managed, properly designed portfolio. I encourage all investors to carefully review their portfolio, its investments and how it is being managed

I cover this extensively in my book Who’s Investing Your Money? – 7 Key Questions to Ask Your Financial Advisor. This book examines the various types of advisor registrations, their limits and abilities and will help you find the right advisor for you.

To learn why mutual funds may not be the best investment choice for your portfolio, please call me at (604) 855-6846 or email me at aspitters@pfcwealthsolutions.com 

Who’s investing your Money? is available as a free PDF download at www.whosinvestingyourmoney.com

Alternatively, the book is available from Amazon.ca as a paperback and Kindle version from this link: Who’s Investing Your Money? – Amazon

[1] “The Problem with Mutual Funds | Rockmoor Wealth Management.” N.p., n.d. Web. 16 Jul. 2019 https://rockmoorwealth.com/the-problem-with-mutual-funds/

[2] How Many Stocks Do I Need for a Diversified Portfolio?” The Globe and Mail, 12 May 2018, www.theglobeandmail.com/globe-investor/investor-education/how-many-stocks-do-i-need-for-a-diversified-portfolio/article19165150/

[3] Krejca, David. “How Many Stocks Make Up A Well-Diversified Portfolio?” Seeking Alpha, 16 Sept. 2016, https://seekingalpha.com/article/4006697-many-stocks-make-well-diversified-portfolio

[4] Chen, James. “Closet Indexing.” Investopedia, Investopedia, 21 July 2019, www.investopedia.com/terms/c/closetindexing.asp

 

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