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More Funds Does Not Mean More Diversified

One mistake I see repeatedly in emails and online discussions is the assumption that holding more funds automatically makes your portfolio more diversified.

For example, in a recent discussion I participated in on the Bogleheads Forum, a new investor was looking for feedback on his proposed portfolio. In addition to a few bond funds and international stock funds, the proposed portfolio included all three of the following U.S. stock index funds (all in the same account):

  • Vanguard Total Stock Market Index Fund
  • Vanguard 500 Index Fund
  • Vanguard Extended Market Index Fund

See the mistake here? The Extended Market Index Fund is basically the Total Stock Market Index Fund, minus the holdings that appear in the 500 Index Fund. In other words, the investor owns multiple U.S. stock funds, but that’s not adding anything meaningful to his underlying holdings. He’s no more diversified than he’d be if he just bought the Total Stock Market fund.

It’s akin to going to your favorite pizza joint, ordering a slice of cheese pizza, paying for it, then ordering and paying for another slice of the same thing–and repeating the process until you’ve purchased 8 slices. It would have been easier (and probably less expensive) to just buy one pizza.

Other Cases of Unnecessary Fund Duplication

The same sort of thing occurs frequently with international stock funds. Vanguard’s Total International Stock Index Fund already includes emerging markets, European markets, and Pacific markets. There’s no need to hold individual funds for each region.

Ditto for bonds. If you own a fund that tracks the Barclays Capital U.S. Aggregate Float Adjusted Bond Index (e.g., Vanguard’s Total Bond Market Index Fund), you already own Treasury bonds, government mortgage-backed bonds, and corporate bonds. So adding category-specific bond funds won’t necessarily make you any more diversified.

“Slicing and Dicing” to Achieve a Specific Allocation

Despite the above, there are cases in which it would make sense to own a fund that invests in a particular sub-category of stocks or bonds. For example, if your 401(k) has access to a low-cost S&P 500 index fund, but no low-cost small-cap or mid-cap funds, it would be perfectly reasonable to hold the S&P 500 fund in your 401(k) and complement it with an extended market index fund in your IRA.

Or, you may have a legitimate reason to overweight a particular industry or style of stocks or bonds relative to its market weighting. For example, many investors choose to overweight small-cap and value stocks because they want the additional expected return that comes with the increased risk.

The key distinction here is that it makes sense to increase the number of funds you own if that’s what it takes to achieve your target asset allocation. But owning more funds does not, in itself, make you more diversified.

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Comments

  1. I can think of two other reasons to minimize # of funds
    #1 automatic rebalancing
    If you own Vanguard’s total international Stock index fund the fund will rebalance for you. If you own emerging, pacific, European, etc you will have to rebalance them yourself.

    #2 Lower transaction costs
    If you have to pay any transaction costs to buy or sell it will be less buying fewer funds (one purchase of total international fund, instead of one for emerging, plus one for pacific, plus one for European etc.)

    -Rick Francis

  2. If I try to track some of the different funds like large vs small vs total, at least on Schwab, some of the ETF’s have different performances that seem to make a difference over time.

    I like the idea of minimizing the number of ETF’s but would some increase in performance be missed?

  3. Rick: Good points.

    Brian: I’m not 100% certain I understand your question. Could you give an example?

  4. Sure, if you compare SCHB to SCHC the returns over 1 year for instance has about a 5% difference in return. If I only had held SCHB over that time period vs also having SCHC would that difference in return matter?

  5. Yes, there is absolutely a meaningful difference between the two.

    SCHB attempts replicate the performance of an index that tracks the 2,500 largest stocks in the Dow Jones U.S. Total Stock Market Index.

    SCHC is an international small-cap ETF.

    So if you hold SCHC and SCHB instead of just SCHB, you’ll have more in small-cap stocks, and more in international stocks. And yes, that can absolutely lead to a meaningful difference in returns.

  6. Fail… I meant SCHA.

    Which was your original reply. I guess I just found myself overweighting the small stocks by also buying SCHA. SCHA does have about a 5% higher return that SCHB over 1 year.

  7. Heh. That’s funny. Yeah, I assumed you meant SCHA. Then I reread it and saw that that’s not what you said.

    In any case, for the benefit of other readers who didn’t see it, here was my original answer regarding SCHB + SCHA vs SCHB alone:

    SCHB attempts replicate the performance of an index that tracks the 2,500 largest stocks in the Dow Jones U.S. Total Stock Market Index.

    SCHA seeks to replicate the performance of an index that tracks stocks #751-2,500 of the Dow Jones U.S. Total Stock Market Index.

    So if you hold SCHA and SCHB instead of just SCHB, you’ll be overweighting the smaller stocks in the index. (And yes, that can definitely lead to a meaningful difference in returns.)

  8. Thanks for the help as always. I’m always interested in the asset allocation business.

    Right now I’m over-weighted in the Bond ETF and international ETF’s as I don’t trust the US markets.

  9. Brian,
    Something to consider on the bonds- we are at historically low interest rates. The value of existing bonds goes down when interest rates rise, because newer bonds will have higher interest rates. This means bond funds decrease in value when interest rates rise. The longer the term of the bonds the more they drop in value.

    I don’t think it is a bad idea to hold some bonds but you may want to avoid long term bonds, and you might not want to over-weigh bonds too much.

    -Rick Francis

  10. Thanks for the info. I’m very new to the investing world.

    It’s the SCHZ, Schwab bond tracking ETF that follow Barclays Capital U.S. Aggregate Bond Index.

    Is this long term bonds? I was planning on lessening my weight in bonds after the market starts to stabilize (i.e. after the whole debt ceiling stuff.. which would be now).

  11. Brian,

    SCHZ is a bit odd in its makeup. (See here.) If you scroll down to the “Bond Maturity Breakdown” section, you’ll see that it doesn’t actually match its benchmark all that closely. It’s heavily weighted in both short-term bonds and long-term bonds, with little in the middle.

    End result: It’s an intermediate-term bond ETF, despite having few intermediate-term bonds.

    (Disclaimer: The above is just information about the ETF. It’s not meant to encourage or discourage the holding of long-term bonds.)

  12. Hm. Thanks for the info.

    Wish I knew some more of this stuff. But it’s why I enjoy reading your site!

  13. In case it wasn’t obvious, I didn’t know that off the top of my head. I just looked it up and shared what I found. 🙂

  14. Stock overlap has been a problem ever since pooled investments became available. Morningstar has a tool that will help you detect this issue as you can run a report that will show you the underlying holdings and the total percentage they represent of your portfolio.

    One of the funnier things that I’ve seen as an advisor is when dozens (literally) of different mutual funds and ETFs are held by an investor who believes he/she is highly diversified only to find that they’re all large cap U.S. stocks with 8 to 10 funds holding the same stocks. Commonly, an investor would hold 4 or 5 funds in a retirement plan, 4 to 7 more in an IRA, and another half dozen or more in a 529 plan. Add the spouse’s accounts and BAM – big mess of the same stuff over and over again. It’s not the worst of problems, but a problem nonetheless.

  15. I agree.
    My equities are 50% global developed fund and 50% global emerging markets fund (index tracker or UK listed investment trusts).
    I also hold a lot of cash. My cash holding equals my equity holding. Cash is in various currencies as I work as a hydrographic surveyor in various countries.

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