Closets Are For Clothes, Not Fund Managers!

It’s right there on page 227 of my 1990s copy of Random Walk Down Wall Street.

By the time the portfolio contains close to 20 equal-sized and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by about 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.

Academic literature backs this up.

My problem is that mutual fund managers never seem to have read any of it, because when I look up the number of holdings of most mutual funds, I’m stunned.

Fidelity’s Magellan Fund – 249 different stocks. As in, a quarter-of-a-thousand.
American Funds – Investment Company of America – 154 stocks and 111 bonds.
American Funds – Growth Fund of America – 275 stocks.

And these are some of the biggest funds in the world.

Now you might ask: isn’t owning 200 stocks just diversification? Isn’t that a good thing?

Before I answer, let me clarify one point for those who have heard me rant about diversification before.

Should the opportunity ever present itself, I would theoretically consider putting my entire net worth in a single investment. As investors in my portfolios know, I believe strongly in taking meaningful positions in the stocks you own. Great opportunities are just that rare. However, if you were to next ask me how often I really expected to be presented with the kind of opportunity that deserved all my net worth, I’d say: never. Those opportunities don’t exist in the stock market.

So, back to that question about owning 200 stocks. I do believe that some diversification is a good thing. However, and this is really my point, over-diversification is not. It’s bad. Very bad, actually, since over-diversification is by definition added expense with no reduction of risk.

What those fund companies above are doing is creating “closet index funds” that basically mirror the broader stock market, while charging you actively managed fund prices. As John Bogle, the godfather of index funds, once said about mutual funds, “The scandal is not what’s illegal. It’s what’s legal.”

If you get proper diversification with 20 stocks, then why pay the extra expense of researching 200 more? That added expense doesn’t lower investors’ risk – it just decreases their returns. From the fund company’s perspective, though, it certainly decreases the odds that investors leave the fund.

Now, to be clear, this isn’t entirely the fault of mutual fund managers. The funds themselves have restrictions on how much of their portfolio they can invest in any one holding, and as these funds approach behemoth size, there are effectively more restrictions on them. That’s a good argument for investors to stay away from behemoth mutual funds, too, by the way.

But I do think some managers hide behind those fund-imposed rules, too. They are simply protecting their collective behind. It’s that old saw, “It is better to fail conventionally than to succeed unconventionally.” And that manager knows if he spreads out his client’s dollars across hundreds of holdings and one does poorly, no one will notice.

I take a different approach at my firm. And so do these other Spoke Fund® guys. I have 16 companies in my main portfolio – and that number will likely drop before the end of this year. I’d like to think my investors get what they pay for – and that’s not a manager that over-diversifies and hides his stock picks in a forest of holdings. I do my homework, pick a few great companies, and stay on top of each of them. And if my investors call with questions about the companies we own, we actually talk about them.

You think a mutual fund manager is really on top of the 233rd holding in his fund?

Quick note on that picture above:

Two years ago I sent a buddy serving in Iraq a package containing a handful of Keys-ey trinkets to help with morale – things like playing cards with flamingos on them, saltwater taffy, margarita mix, and a T-shirt like the one above that I found down in Key West. I also offered him $50 if he emailed me a picture of himself wearing it, surrounded by the other guys in his platoon.

I am still waiting for that picture. And though I’m happy to say that Greg has since arrived home safely, the shirt, oddly enough, did not make it back.

Happy Veterans Day.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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