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Mutual funds are by their nature a collection of various individual stocks or bonds and other underlying investments. By holding several funds across asset classes investors can easily build a diversified portfolio. Diversification is a good thing, but how many mutual funds are too many? 

How to Diversify?

Some might argue that sufficient diversification could be achieved using as few as two mutual funds. For example the Vanguard Total Stock Market Index fund (VTSMX) and the Vanguard Total Bond Market Index fund (VBMFX) have a correlation coefficient of -0.30 for the trailing five years which Morningstar Inc. (MORN) defines as being moderately negative. Given that an investor would have the domestic equity and bond markets covered you could argue that this is a well-diversified portfolio. Add an international fund and perhaps a small cap and a mid-cap fund and this might truly be a fully diversified portfolio. Index funds lend themselves well to asset allocation and portfolio diversification. (For more, see: What Does it Mean if the Correlation Coefficient is Positive, Negative, or Zero?)

Some investors and financial advisors like to add some additional asset classes to achieve the portfolio’s objectives. Beyond what might be considered core stock and bond asset classes, things like alternatives, real estate, emerging markets equity or fixed income, foreign bonds, Treasury inflation protected securities (TIPs), commodities and other asset classes may be appropriate for a given investor’s portfolio. This will entail owning an additional number of mutual funds or exchange traded funds (ETFs). If these asset classes are appropriate there is nothing wrong with this.

Do More Funds Enhance Diversification?

Many years ago a client engaged my services to review their portfolio. The client was certain that their portfolio was well diversified in that they held several individual stocks and 19 mutual funds. After examining the funds, I pointed out that there were several stocks that were among the top five holdings in all 19 funds and the level of stock overlap was quite heavy. Essentially these 19 mutual funds all invested in similar stocks and had the same investment objective.  While this client held a number of different mutual funds he certainly was not diversified. (For more, see: What Is the Best Way to Diversify an Investment Portfolio?)

There is no magic number of mutual funds that is right for a particular portfolio. However at some point you have to wonder what value five or 10 additional funds are adding. Many brokerage wrap accounts seem to hold quite a high number of mutual funds. Generally the funds are not the cheapest in terms of expenses and often include revenue sharing arrangements featuring the 12b-1 fees from the underlying mutual funds in addition to the wrap fee being charged by the brokerage firm. (For more, see: 12b-1: Understanding Mutual Fund Fees.)

A great starting point in building a mutual fund portfolio is your asset allocation. If your allocation includes six, nine, 12 or some other number of asset classes start with a mutual fund for each asset class. Even better look to use a low cost, style true index fund where possible. What does your portfolio look like? If you feel tempted to add additional mutual funds ask yourself what will they bring to your portfolio. Enhanced returns? A lower overall level of risk? (For more, see: Achieving Optimal Asset Allocation.)

It’s fairly easy to acquire a collection of mutual funds. Several old 401(k) accounts from former employers, a taxable brokerage account or two, individual retirement accounts (IRAs) and other accounts can add up to a number of mutual funds quite easily. This is tough to properly monitor for financial advisors with the proper tools let alone for the average individual investor.

Does Your Advisor Have a Vested Interest?

One of the places that I’ve seen mutual fund portfolios with a large number of holdings are in accounts with some of the major brokerage firms including wrap accounts. You should always understand all ways in which your financial advisor is compensated including compensation directly from mutual funds he or she might suggest. Does the advisor receive an up-front load or sales charge or perhaps trailing compensation from the mutual funds in terms of 12b-1 fees? Their firm may have an arrangement that incentivizes them to offer a number of funds from particular families including proprietary funds offered by the advisor’s employer. (For more, see: Paying Your Investment Advisor - Fees or Commissions?)

The Bottom Line

Mutual funds remain the investment of choice for many investors. It is possible to construct a diversified portfolio using just a few — index, actively managed or a combination of the two. Holding too many mutual funds can make it difficult to monitor and evaluate your funds. Additionally some brokerage accounts might include incentives to use a certain number of mutual funds of selected fund families. If a financial advisor is suggesting what seems to be an excessive number of mutual funds ask them why and what added value these extra funds add to your portfolio. (For more, see: 2015's Most Promising Mutual Funds.)

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