One question investors often ask me as they review their investments at the start of a new year is how many funds or ETFs should be in a portfolio. There is no one right answer, but the key is to find the right balance. If you have too few, or poorly matched, funds, you are taking on more risk than you need to. On the other hand, if you have too many funds, there is likely going to be too much overlap and the portfolio will suffer. So how do you go about finding the right balance?
For most investors, a good portfolio will be a mix of cash, bonds, and equities. Some may want to throw some exposure to real assets or commodities into the mix, but in my opinion, they are more of a complement to an otherwise well-diversified portfolio.
Diversification is key
Within the fixed-income portion of the portfolio, at the very least, one should have exposure to government bonds and corporate bonds. If you want to get a bit more sophisticated, you may want to bring in some exposure to global bonds, high yield, floating rate notes, or even convertible bonds.
On the equity side, you will want to have exposure to some Canadian equity, but also stocks from the U.S. and around the world. In addition, you may also want to add some small and mid-cap stocks into the mix, as well emerging markets, Japan and other parts of Asia. Then for a bit of added spice, you might want to add some sector exposure such as healthcare, science and tech, and resources. I have even had some who want to bring style diversification into the mix, bringing in growth, value, and core equity holdings.
An embarrassment of riches
Looking at this list, it is pretty easy to see that the number of funds in a portfolio can get up there pretty quickly. Even without taking style diversification into the mix, there would be about eight bond funds and 14 equity mutual funds in a portfolio, if every asset class mentioned were included. If we bring style into the equation, it would bring another six funds into the portfolio, bringing the grand total up to 28.
Clearly this is overkill. But interestingly enough, I once had an advisor bring me the portfolio of a new client that had 33 mutual funds in it! That’s ridiculous. It got even worse when I started digging deeper into the holdings, because there were seven different balanced funds.
A balanced fund by its nature is already well diversified, typically providing exposure to a mix of stocks and bonds, quite often with exposure from around the world. In theory, if you found the right balanced fund, it could quite easily be your only holding.
Most with the least
The reality is that most investors will want to have more than one fund in their portfolio. I can’t say that I disagree with that. When I build a portfolio, I try to get the most amount of diversification with the least number of funds. I have found that it is quite possible to build a very well diversified portfolio with anywhere between three and eight funds.
At the low end of the range, a well-diversified portfolio can be created using one high quality bond fund or ETF, a large cap Canadian equity, and a global equity fund or ETF. At the upper end of the range, you will want to have three bond funds: a high quality bond offering, a global bond offering, and a high yield offering. You will then want to hold four or five quality equity offerings: Canadian equity, global equity, small cap, and a couple of sector funds.
— Courtesy Fundata Canada Inc. © 2014. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.
