Mutual Fund Holdings and Diversification

On 10/05/2010, in Mutual Funds, by Jordan Wilson

Investors like mutual funds because they are a simple way to diversify one’s portfolio on a cost-effective basis.

When investing in funds, individuals need to ensure that they are truly diversifying. Often investors think they are diversifying, but in actuality they are not doing an effective job.

Today, we will take a look at ways to ensure you properly diversify.

If you would like a refresher on diversification, please review my earlier posts on the subject here, here, and here.

Intra-Fund Portfolio Analysis

When analyzing a fund for investment, consider the diversification within the specific fund.

To do that, review the fund’s investment portfolio.

Concentration of Key Holdings

Your focus should be on the largest holdings as a percentage of the total portfolio.

I like to look at the top 10 holdings and often even the top 3 or 5 investments as well.

You want to ensure that a small number of investments do not have too great an influence on the fund’s total performance. If this occurs, the benefits of diversification may be reduced.

There is no magic number as to what proportion should make up the top 3, 10, or 20 holdings. The right mix will differ depending on the type of fund and the views of each investor.

For example, Fidelity Large-Cap Value (symbol: FSLVX) is a U.S. equity fund that invests in U.S. domestic and foreign companies. Its top 3 holdings account for 11.55% of fund assets. Its top 10 holdings account for 28.82%. Some might view these percentages as a little high given the breadth of available investments. Others may not.

If we compare that with the JP Morgan Russia Select (JRUSX) equity fund, we see less diversification in the JP Morgan fund. Its top 3 holdings make up 30.89% of the fund’s assets and its top 10 holdings are 67.31%. This indicates that a heavy concentration of fund assets lie in 10 or fewer investments.

I would suggest that the benefits of portfolio diversification are lower in the JP Morgan fund versus the Fidelity fund.

But this is not surprising.

Be Cautious with Specialized Funds

The more specialized an investment style, the less possible investments exist for inclusion in a fund’s portfolio. The less available investments, the greater potential for poor diversification.

The investment universe for Fidelity’s Large-Cap Value fund should be significantly larger than for JP Morgan’s Russia fund. As such, I would expect less diversification within the JP Morgan fund relative to Fidelity.

When analyzing niche funds, it is important to take this into consideration.

Another diversification consideration for many specialized funds is that there will be a high degree of correlation between the assets held in the fund.

Even if there is a wide variety of investments held in the JP Morgan fund, the benefit of diversification may be lessened due to the high correlation between investments.

If Russia enters into a country-wide recession or depression, that will affect almost all Russian companies to some extent. However, Russian economic difficulties will have less impact on the companies held in Fidelity’s fund of U.S. and foreign listed stocks.

Comparison to Peers and Benchmarks

As with all other analysis, always compare a fund’s diversification against its peer group and the components of its benchmark.

For example, the Large-Cap Value funds include the American Century Value B (ACBVX), Morgan Stanley Inst Value Invmt (MPVIX), and Vanguard U.S. Value (VUVLX). Also, according to the Fidelity Large-Cap Value fund profile, suitable benchmarks may be the Russell 1000 or Standard & Poors (S&P) 500 indices.

Just looking at each fund’s holdings, we see the following for their top 3 and top 10 percentages of total holdings: American Century: 10.24%, 27.51%; Morgan Stanley: 13.17%, 31.68%; Vanguard: 9.42%, 24.37%. Not significantly different from the Fidelity allocations.

If we compare to the Russell 1000 or S&P 500 indices, the differences are more pronounced. The Russell 1000 index top 3 and top 10 holdings make up 6.6% and 16.70% respectively. The S&P 500 are 7.43% and 18.94%. Probably not a cause for concern, but there is a difference.

Again, this is not surprising. The benchmark contains all its holdings, both strong and weak. One expects that the fund manager would avoid the obvious weak components of the benchmark index and over-allocate to components that the manager expects to outperform. Hence, you would expect a greater concentration in certain holdings.

Of course, whether the fund manager is correct in his allocations is a topic for another day.

Inter-Fund Portfolio Analysis

I suggested previously that you should compare the concentration of key holdings between different funds within the same peer group.

If you intend to invest in multiple funds, it is equally important to compare actual holdings in the different funds.

If not, you may end up with too much exposure to the same investments.

Avoid Investing in the “Same” Fund Twice

In essence, you will be paying twice the management fees for acquiring the same assets. A poor recipe for successful investing.

In our example above, I randomly chose the Large-Cap Value funds from Yahoo Finance. So there was no manipulation on my part.

If we look at the top 10 holdings for each fund, which make up between 25%-32% of total holdings, we see some investment overlap.

All 4 funds have JP Morgan and Pfizer in their top 10 holdings. Not significant, but still a doubling up of 2 core holdings.

But if we exclude the Morgan Stanley fund, the other 3 funds also all share top 10 holdings of Chevron, General Electric, and Exxon. That means that American Century, Fidelity, and Vanguard have the same 5 of their top 10 holdings. Not too much difference between these funds in respect of their key holdings.

And the difference between Fidelity and Vanguard is even less. These two funds share 8 of the same top 10 holdings (they both own Bank of America, Merck, and Wells Fargo). Without digging deeper into each’s portfolios, there is an overlap of 80% of their key holdings. Not a good way to diversify between funds.

I would expect that the gross fund returns for both would be close.

In fact, their net returns for the prior 1, 3, and 5 years were respectively: Fidelity: 0.14%, -13.40%, -3.79%; Vanguard: 2.97%, -11.30%, -3.66%.

The difference in performance is likely due to: some differences in investment selection; the timing of purchases and sales of holdings; management fees and the total expense ratios; etc.

If you want to diversify in funds, make sure that you are not buying essentially the same fund under a different name.

Another Issue with Speciality Funds

This is also a problem with specialized investment styles.

The smaller the number of investment options, the more likely that funds within the same style will have common holdings.

If you intend to acquire specialized mutual funds, I suggest you limit your investment to one fund in each category.

While you may not always end up with the top performing fund, you will avoid potentially overlapping your underlying investments and paying twice the fees.

Be Careful Across Styles As Well

Some investments seem to crop up in many different investment categories.

Just because you own two mutual funds of differing style, you may end up with some similarities in holdings.

For example, perhaps you own the Credit Suisse Large-Cap Blend A (CFFAX) mutual fund that invests primarily “in equity securities of U.S. companies with large market capitalizations.” You have heard that diversification is useful and wish to expand your investment horizon.

An investment advisor has told you to consider investing in global equities as well as in the banking sectors. His research indicates that both sectors should perform well and it would give you added diversification. He recommends two funds: T. Rowe Price Instl Global Large-Cap Equity (RPIGX) and the Schwab Financial Services (SWFFX).

Yes, you will get some diversification from adding these to your existing Credit Suisse fund, but is it as good as the advisor states?

Again, you need to look at each fund’s core holdings.

The top 10 descending holdings for the Credit Suisse fund are: Microsoft, Chevron, Berkshire Hathaway B, Google, JP Morgan, Wells Fargo, AT&T, Occidental, Philip Morris, Verizon.

The top 10 for T. Rowe Price are: Apple, Google, JP Morgan, Roche, Merck, Mitsubishi, Qualcomm, Wells Fargo, Axis Bank, DP World.

The top 10 for Schwab: JP Morgan, Goldman Sachs, Bank of America, Prudential, Citigroup, Wells Fargo, American Express, Metropolitan Life, Travelers Companies, Unum Group.

Even within these different investing styles, we see some overlap in holdings.

And if you look back to our earlier example, you will see JP Morgan in all 4 funds we compared. Chevron makes an appearance in 3 of the funds. And Wells Fargo is a core holding of both the Fidelity and Vanguard funds above.

The overlap is not huge in this example. But be aware that it can occur to varying degrees even amongst funds with different styles.

Always make sure you check to avoid getting too much exposure to any one holding.

2 Responses to “Mutual Fund Holdings and Diversification”

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