Fribble The Hidden Cost of Diversification

By DSchlege@LoderDrew.com
August 14, 2000

The following classic Fribble first appeared December 1, 1998.

I am not too old (37) to remember the days when mutual funds were an obscure side bet in a serious investor's portfolio. Just 15 years ago, financial planners and investment advisors pushed a combination of stocks, Treasury notes, bonds, annuities, life insurance, and real estate as an overall strategy for wealth accumulation and security. Over the past 10 years, mutual funds have eclipsed all these other vehicles and now almost every advisor preaches to the altar of mutual funds, particularly for the younger investor. We all understand the benefits of diversification inherent in mutual funds, and we've enjoyed their wonderful net returns over the past 10 years; but the recent late-summer stock swoon made me realize a couple of things about the mutual funds I own.

Due to compulsory diversification, the ownership stakes in the individual stocks owned by the funds are diluted to the point of inconsequence. This could be a benefit when one or two stocks take a big nosedive; but how often does this occur these days? Generally, individual stocks have been moving in synch with the overall market. I have yet to see one of my funds beat the S&P 500 in an up or down market. Did I make poor choices by selecting funds with poor managers? I look to see if other funds are beating key indexes and I notice it is indeed a very rare, non-recurring event. Even S&P index funds can't beat the real S&P because of expenses. So why is it these funds can't beat the indices, or even my own portfolio of individual stocks?

I looked deeper into the operating results of my funds to find an answer. First, maybe you're hit with a load, and then there are the annual expenses. Then, the fund's stock mix is spread too thin to overcome overall market fluctuations. So if there is an on-the-ball analyst making good picks, they are offset by the mediocre picks of other analysts. Why don't my fund managers go heavier on the picks of a hot analyst? Why can't they weight the mix more toward their favorites? People get into these funds as long-term investments, yet the fund managers are churning stocks, incurring expenses and taxes, just to maintain the diversification mandated by their prospectus. This forced diversification is counterproductive and at-odds with the goals of most long-term investors -- buying quality equities over time and holding them, knowing in the end they will weather short-term events and result in good long-term returns.

Diversification could be important if I only had one fund; but most investors, like me, already have a mix of different funds. Diversification isn't helping me when I already have a mix of blue-chip, growth, international, and small-cap funds. And yet, when I look deeper into the mix of these funds, I find myself owning little bits of IBM, Philip Morris, and Dow stocks in each of three different funds. Why am I paying the on-going, annual expenses of these funds to maintain this shell game of diversification? I guess I could invest in specialty funds if I want to focus on certain industries; but these carry even higher costs of acquisition and retention. Given the thousands (can you believe it?) of mutual funds now, I feel like I'm in a Turkish bazaar when I try to select a fund. I look through row after row of storefronts all peddling the same rugs and jewelry. Each store promises me something unique and different, yet upon further inspection I notice the rugs are all the same and they cost more than the same ones I saw at the manufacturer last Tuesday.

And yesterday I received a new insult to my intelligence. My 401(k) plan sponsor is offering portfolios of funds. So now I have the opportunity to pay annual expenses on a fund that holds other funds that also charge annual expenses!

I'm sticking with my Foolish penchant for picking individual stocks I plan to hold for 10 to 20 years. My return is not tainted by the yearly cost of Armani suits and Wharton MBAs. It's working for my portfolio of individual stocks, which consists of a morphed Dow 10, financial stocks, and some high-tech kickers. I have yet to sell a stock -- ever -- and I'm beating the S&P 500. I know the good times can't last forever; but I can (will) diversify with cash-flow real estate, bonds, etc. I don't need to pay for an analyst to help me diversify -- it costs too much. Sometimes we look back smugly on the ways of the last generation, but their Foolish, simple methods can often outperform the glossy hype of the mutual fund peddlers.