How Many Is Too Many?

|
Includes: JABAX, PFRAX, PTTRX, TBGVX, VBMFX, VBTLX, VCAIX, VEIEX, VEIPX, VEURX, VEXMX, VFINX, VFSTX, VGENX, VIGRX, VISGX, VPACX, VSMAX, VSMGX, VTIBX, VTMGX, VTSMX, VTWSX, VWEHX, VWIGX, VWNFX
by: Tom Madell
Summary

This article tackles the somewhat controversial question of whether one does just as well owning just one or two funds as a whole handful.

The question boils down to two main issues.

a) Will you be diversified enough with just a few funds?

b) if you choose a bunch of funds to seek enhanced performance, are you knowledgeable enough to pick the right funds in advance?

Bottom line: There is no one answer for everyone but if you choose to own lots of funds, you will want to compare results to see if it's really worth it.

A reader of my newsletters recently raised an important question: Does an investor really need to own a lot of funds/ETFs, or, can one still expect to obtain good results with a much more limited number of funds, or perhaps, even with as few as one? More specifically, it seems, he was indirectly questioning the need in my last Model Portfolios (Oct. '18) for so many funds (15 stock funds and 11 bond funds to be exact). Even my new "Recommended" stock and bond fund listings (see below), which now replace my Model Portfolios, now show 20 funds altogether.

Great question! Let's be honest - it would be highly difficult, and most likely unnecessary, for most investors to acquire each and every one of my recommended funds. (Even I don't own all 26 of the Oct. '18 funds, although I do own all of the 20 funds listed below. By way of explanation, I have been at this for more than 2 decades and once I find a fund I am satisfied with, I rarely close it out, thus leading to perhaps too many funds - yes, I admit it.)

But for the typical investor, you likely don't need nearly as many funds as I own or even recommend. That would make my prior use of the term "Model Portfolios" perhaps somewhat inexact. On the other hand, now using the term "Recommended Funds" makes clearer that no one should really try to emulate the exact collection listed, but only consider owning as many or as few of the funds as make sense to you. In other words, each recommended fund might be considered as a possible inclusion in starting a portfolio, or filling a hole in an existing one.

So what are the advantages, if any, of having a number of funds as opposed to just one or two? The most important one might be considered fairly obvious. As you own more different types of stocks and bonds, this will help ensure that you will be sufficiently diversified. On the other hand, stocks and bonds of a similar type may yield highly overlapping results which may add only a trace of additional diversification, and not worth the burden of added paperwork and other complexities.

Although some funds/ETFs may appear diversified, a close analysis might reveal a nearly complete lack of certain types of investments. For example, returning to the reader mentioned at the onset, he noted the excellent long-term performance of the Janus Henderson Balanced Fund (JABAX), suggesting that this single fund might be a good alternative to owning the multiple stock and bond funds recommended in my Oct. '18 Model Stock and Bond Portfolios. ("Balanced" funds will invest in both stocks and bonds within a single fund.)

While it is true that this fund would have outperformed the combined return of my Model Portfolios if examined over the last 4 to 5 years, it had virtually no international stocks. Since international stocks were considerably poorer performers over the period than US stocks, and my Portfolio did include a large proportion of them, it makes sense that JABAX would outperform during those years. While some might argue "no problem" since in their opinion, international stocks are not necessary (or desirable) in a portfolio, most others would disagree.

So if sufficient diversification is a sound objective, the question becomes how should we define "sufficient?"

Here's where the experts might again differ. A few might say you can be diversified enough with just one or two well-chosen funds, but most others, including me, think you are better off with at least a few more.

Let me acknowledge that you could consider yourself sufficiently diversified by merely owning a single fund, but only IF you are willing to define "diversified" solely as owning a large number of stocks (or bonds) which almost all mutual funds do. After all, investors in individual stocks are often advised to own as few as a few dozen stocks to achieve diversification, and mutual funds or ETFs almost always have far more than that. But given that there are thousands of US individual stocks (not to mention bonds), and many more if you add in international ones, how can you be sure a single fund is exposing you to enough of these, and especially to different types of investments?

If diversification is broadened to mean owning a sample of nearly everything, some investors might view this as watering down your potential for big gains. On the other hand, a too-limited sample subjects them to the risk of bigger losses as well. An investor who owns just one or two funds that have a particularly bad year or two does not gain the potential "insurance" of having a few that may likely serve to somewhat offset the bad performance.

Your best chance of being sufficiently diversified with just a single fund is to pick an index fund that indeed attempts to sample all stocks rather than a more limited subset, such as just Large Cap Growth stocks. Such funds typically include the word "Total" in their name, such as "Total Stock Market Index" or "Total Bond Market Index." Of course, merely being an index fund that does not broadly sample does not suggest the fund will be very diversified since it may focus only on certain types of stocks (or bonds). Note that even the tremendously popular S&P 500 index funds or ETFs aren't truly diversified because they are almost completely large cap in composition with small cap stocks excluded.

But even the word "Total" in the name may not suggest a fully diversified fund. Why not? Because the fund may only include US stocks (or bonds) and to be fully diversified, most investors may want to have exposure to international investments, as suggested above. Therefore, looking for the words "Total World" will imply diversification internationally as well as domestically.

While these broad index funds may be sufficiently diversified for some, you still may not be getting much exposure to some types of stocks (or bonds). For example, Vanguard Total World Stock Index Fund Investor Shares (VTWSX) also has scant exposure to small-cap stocks. So, if you want such to be included, you might have to add another fund. And if you want meaningful exposure to International bonds, you will need to go beyond just Vanguard's Total Bond Market Index Admiral (VBTLX) which basically only includes US bonds.

Already, then, you may need a minimum of four funds. But instead, though, you might select Vanguard LifeStrategy Moderate Growth Fund (VSMGX) which is made up of US and International stocks and bonds. Once again, however, there is very limited exposure to small-cap stocks.

If you either don't have the time, interest, or presumed knowledge to select any more than a very few funds, or have come to accept the notion that merely performing in line with what the overall market does is the best strategy, then a small number of index funds may be diversified enough to accomplish this. But some investors such as myself, on the contrary, having the desire to attempt to position their investments, may wish to create a portfolio that aims to maximize certain types of investments based on the expectation that this may produce better results than merely accepting what the overall US stock (or bond) market or broad international stocks (or bond) investments do. For example, such investors may conclude that, in particular, adding additional Growth stocks and/or Emerging Markets stocks to the portfolio may be an even better strategy. Likewise, some investors may see particular value in certain types of bond funds, such as high yield or municipal bond funds.

There are literally dozens of fund categories that such investors might choose to accentuate in their portfolios, either "standalone," or in addition to the broad market index funds that may give only a small sampling, or none at all, of what they deem to be potentially "favorable" areas to include. Depending on their actual choices, such investors may still remain quite diversified, or, they may place big bets on only certain corners of the markets.

By investing in managed, rather than, index funds, investors too are hoping for better returns than achieved by merely accepting "total" market returns. But here too there may be a problem of too little diversification if the fund, for example, invests heavily in one sector of the stock market, or fails to invest in another. So, in order to remain diversified, an investor in a single managed fund may need to invest in several more to achieve that diversification.

So you can see how some investors' portfolios can grow quite large. Will these investors necessarily do better than an investor who only invests a small number of funds, or even just in the Vanguard LifeStrategy Moderate Growth Fund? There is no way to know in advance but I suppose it depends largely on how accurately each investor has judged in advance which fund categories and specific funds will do better than the performance of the total stock and bond markets. This is extremely hard for any investor, or even financial professional, to accomplish, even though the entire financial industry is based on the premise that knowledgeable managers, and perhaps, a small number of individuals will be able to do so.

As an aside, it is ironic that a whole industry, employing perhaps a million or more, continues to thrive in the absence of demonstrable evidence of effectiveness; we know that year after year, most fund managers do not consistently beat the broad market indexes. Perhaps it merely reflects the investing public's lack of confidence in their own ability to manage their investments themselves (or sufficient time to do so).

Bottom line: In the end, individual investors must decide for themselves the number of funds they want to invest in, as there is no "right" or "wrong" answer. Given that, it would be worthwhile for investors choosing more than a handful of funds to periodically check to see whether their choices as a whole are doing better than the option of sticking to just a very small number of funds.

As an example, I conducted a comparison of the performance results of investing an equal amount in six of my most frequently recommended domestic and international stock funds over the following five years starting in March 2014 with that of just one Total index stock fund, namely VTWSX. The results showed my six funds, as a group, did better by about 1.5% annually.

Additionally, I compared five of my most frequently recommended bond funds against an 80%/20% split between VBMFX and Vanguard Total Intl Bd Idx Investor (VTIBX). In this comparison, once again, my recommendations came out ahead, this time by 0.75% annually. (Note since my portfolio included a municipal bond fund only suitable for a taxable account, the higher after-tax return for this fund would have additionally boosted my portfolio's return. See the Footnote below for the specific stock and bond funds included in these comparisons.)

Recommended Funds

Stock Funds

Since I last reported in my Feb. Newsletter, a new fund has now grown enough to be included as one of my biggest holdings, Vanguard Small-Cap Index Fund Admiral (VSMAX), bringing the total number of stock funds to 13.

Here is the latest data on how my recommendations have done over various periods of time, as of 2-28-19. Every return in bold did better (or equal to) their respective comparative index fund (shown below the table) over that interval.

Fund

Fund Category

3 Mo. Return

1 Year Return

5 Year Ann. Return

10 Year Ann. Return

15 Year Ann. Return

-Vanguard Small-Cap Index Fund Admiral (VSMAX)

Small-Cap Blend

4.2

7.8

8.0

18.1

9.4

-Vanguard Extended Market Idx (VEXMX)

Mid-Cap Blend

4.6

6.7

7.8

17.6

9.2

-Vanguard Small Cap Growth Idx (VISGX)

Small Cap Growth

6.4

11.6

8.0

18.5

9.7

-Vanguard 500 Index (VFINX)

Large Blend

1.4

4.5

10.5

16.5

8.2

-Vanguard Equity Income (VEIPX)

Large Value

0.8

4.9

9.6

16.2

8.7

-Vanguard Windsor II (VWNFX)

Large Value

0.7

1.7

7.5

14.8

7.4

-Vanguard Energy (VGENX)

Sector

0.8

-2.0

-3.0

6.1

7.1

-Vanguard Growth Idx (VIGRX)

Large Cap Growth

3.5

5.4

11.1

17.2

8.9

-Vanguard Pacific Index (VPACX)

International

1.9

-8.0

4.6

9.6

5.3

-Vanguard International Growth (VWIGX)

International

5.3

-5.6

6.2

13.0

7.5

-Vanguard Europe Idx (VEURX)

International

4.7

-5.6

0.9

9.9

5.1

-Vanguard Emerging Markets Idx (VEIEX)

International

6.0

-9.8

3.8

9.9

7.4

-Tweedy, Browne Global Value (TBGVX)

Global

2.4

-0.1

3.8

11.2

6.7

Note: The following shows the returns for the same period for broad stock index funds:

Fund

Fund Category

3 Mo. Return

1 Year Return

5 Year Ann. Return

10 Year Ann. Return

15 Year Ann. Return

-Vanguard Total Stock Mkt Idx Inv (VTSMX)

Large Blend

1.9

5.0

10.0

16.7

8.5

-Vanguard Developed Markets Idx Adm (VTMGX)

Foreign Large Blend

3.8

-5.6

2.6

9.9

5.4

Bond Funds

Fund

Fund Category

3 Mo. Return

1 Year Return

5 Year Ann. Return

10 Year Ann. Return

15 Year Ann. Return

-Vanguard California Interm-Term Tax-Exempt (VCAIX) See Note 1.

Muni Intermediate

2.4

3.8

3.0

4.3

3.6

-PIMCO Total Return Instl (PTTRX)

Intermediate-Term

2.5

2.6

2.4

4.9

4.8

-Vanguard Total Bond Market Index (VBMFX) See Note 2.

Intermediate-Term

2.8

3.0

2.1

3.5

3.7

-Vanguard High Yield (VWEHX)

High Yield

4.2

4.3

4.3

9.5

6.1

-Vanguard Short-Term Investment-Grade (VFSTX)

Short-Term

2.0

2.8

1.8

3.4

3.0

-PIMCO International Bond Adm (PFRAX)

International

2.1

3.7

4.6

6.9

5.5

-Vanguard Total International Bond Index (VTIBX)

International

2.4

4.3

3.8

NA

NA

Note 1: After-tax returns are higher for Muni funds than taxable funds, so in a taxable account, VCAIX would have beaten VBMFX over every period; try to choose a fund with bonds from your particular state. Note 2: The returns of VBMFX, one of my recommended funds, as shown in the table, serves as my benchmark index fund.

---

Footnote: The six stock funds, invested in equal amounts, mentioned in the example above are: VFINX, VEIPX, VIGRX, VWIGX, VPACX, and TBGVX. The five bond funds, invested in equal amounts, also mentioned in the example above are: PTTRX, VWITX, PFRAX, VWEHX, and VFSTX.

Disclosure: I am/we are long ALL OF THE RECOMMENDED FUNDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.