Diversification is one of the first rules that any investor learns; spreading your money across lots of different holdings can reduce your risk and lead to steadier returns over the long-term.
We looked at funds that have between 150 and 350 holdings and found that on average a diversified fund charges 0.74% and beats its Morningstar Category average by only 1 percentage point over a five year period.
Funds with 100 or more holdings in their portfolio are typically thought to be well diversified. A fund with 100 stocks in the portfolio, for example, might have roughly 1% of its assets in each holding. The benefit of this, it is argued, is that if one holding falls, the effect on the fund's overall performance is limited. On the face of it, it's a sensible strategy. But can too much diversification actually mean mediocre returns?
"If you want more outperformance, you probably want to choose a fund that's more active," says Chris Traulsen, director of fund research at Morningstar. "If you invest in a concentrated fund and its manager does a great job, picking all the right stocks, the returns will be greater than those produced by diversified funds."
We found 34 UK-domiciled funds with between 150 and 350 holdings that are dominated in pounds or dollars (some funds had more holdings, but we capped our data set at 350). But just four of these funds beat their Morningstar Category average by more than 3 percentage points over five years.
How Do Diversified Funds Perform?
The 11 sterling-denominated funds in the table below and on average they beat their peer group over five years by only 0.45 percentage points.
The three-star rated Axa Rosenberg Global fund has the largest number of holdings in the list at 339. The fund's largest holding is US tech firm Microsoft, accounting for 2.53% of assets. The top 10 holdings account for just 13.58% of assets in total. The fund has produced annualised returns of 10.84% over five years, beating the Global Large-Cap Blend Equity Morningstar category by 1.55 percentage points a year.
The weakest performer in the list is the two-star rated Dimensional UK Value fund, whose annualised returns over five years are some 2.13 percentage points behind the category average. Surprisingly, despite having 209 holdings in the portfolio, the largest 10 positions account for around 44% of assets.
The JPM UK Equity Core fund, meanwhile, has produced annualised returns of 6.79% over five years, 1 percentage point more than its category. Callum Abbot, manager of the fund, argues that diversified funds are not necessarily designed to deliver high returns.
The fund, which has 155 holdings, aims to beat its benchmark, the FTSE All Share, and cover its fee while being low risk. "People can use the fund as an alternative to a passive fund since we have a better track record and are still cheap, or it can be a core portfolio holding that investors can build risk around," he adds.
To manage risk, the fund can only deviate slightly from its benchmark - holding up to 0.3% more or less in a stock than the index. For this reason, even though he really likes Games Workshop, for example, just 0.4% of the fund's assets are in the stock.
“[With this style of investing] you have smoother, more consistent performance, with no big swings month by month. If one stock doesn’t perform well is not going to blow up the performance of your portfolio,” Abbot adds.
Managers with a concentrated portfolio often consider themselves as owners of the stocks they invest in, rather than just short-term investors. A manager who is monitoring hundreds of holdings is understandably unable to have such a close relationship with the companies he backs.
Jan Sytze Mosselaar, equity manager at Robeco, says: "The disadvantage is that we don't know all our holdings in depth. But our aim to have exposure to different sectors and the best way to achieve that is having lots of different names in the porfolio."
He also points out that not being so close to a company can make it easy to avoid the investment mistake of holding on to a loser: “If a company has a profit warning, I prefer not to hold to that position anymore rather than waiting it gets better.”
How Much Diversification is Too Much?
The traditional argument against holding just a handful of stocks in an investment portfolio is that it ramps up the risk - if one stock tumbles it can have a significant effect on overall performance. But a recent Morningstar investigation found that some of the most concentrated portfolio have produced consistently stellar returns.
For Morningstar analysts, there is no blanket rule on how many holdings a fund should have. The appropriate number depends on factors such as a fund's investment goals and its manager's investment style. Investors looking for a defensive option with low volatility may find a widely diversified fund is the best option for their needs.
But Traulsen points out that the number of holdings in a fund is not always the most important point, rather investors should consider the weighting of the positions. “You can have a big chunk of assets in the top 10 holdings and then a long tail of small positions,” he explains.
For example, the Russell Investments Continental European Equity fund has 316 holdings and just 18% of its assets in the biggest 10 positions, while the Dimensional UK Value fund has 44% of its assets in its top 10 holdings, despite having more than 200 holdings.
One major benefit of a diversified fund, adds Traulsen, is liquidity. A larger number of smaller positions makes it easier for a manager to trade in and out than if he holds a large stake in a few stocks.
But there are downsides to holding a larger number of stocks, too. One of the most obvious is cost; buying and selling shares costs money, so if a manager has hundreds of positions he may rack up far greater trading costs than a manager who is managing just a handful of stocks.
Checking the ongoing charge is crucial when considering any fund and is a helpful indicator in this case too. A fund that doesn’t take on much risk or deviate from its benchmark, but charges a high is "problematic”, Traulsen says.