Terry Tang, Investment Advisor
March 31, 2020The COVID-19 pandemic has led to a global fear-driven sell-off we have never seen since the 2008 financial crisis. Investors are worried that uncertainties surrounding the spread of coronavirus will have a dramatic impact on the world’s economy, and officially ending the longest-running bull market and economic expansion in the United States. If this market downturn has taught us anything, it is definitely the time to re-think your mutual fund strategy.
Arguably, Canadian investors are offered with poor mutual fund choices. Mutual fund industry wants retail investors to believe that it's too dangerous to own individual stocks and so owning a large basket of stocks to reduce risk is the right thing to do. According to Investment Funds Institute of Canada, Canadians invested about $1.82 trillion in investment funds as of February 29, 20201.
When everybody has the same strategy, that is investing in a large basket of stocks through mutual funds, in a bull market that strategy works fine. But in a market downturn, the strategy quickly falls apart because of two factors - over-diversification and fee.
"Why own both good and bad quality stocks when you could own just the ones with strong fundamentals and growth potential?"
The Danger of Over-Diversification
In Canada, a typical mutual fund can have a portfolio of 100 - 500 individual stocks. That’s a lot. And if you own a fund of funds, which is a mutual fund that holds a bunch of mutual funds with different or similar investment mandates, that number of holdings can go up to more than 1,000.
Diversification is important because it can lower the portfolio risk by limiting exposure to any single asset, thus creating an offsetting effect if one asset is performing poorly than the other. But proper diversification can only take you so far, and over-diversification does more harm than good - higher cost, overlapping exposures, and that extra diversification simply does not lower the risk any further. Too many holdings also means you're owning both good and bad quality stocks - this is significant in a down market, because picking quality stocks makes all the difference. Most experts agree that a range of 10 to 30 stocks will provide diversification with the most cost-effective level of risk reduction.
Active Fee, Passive Management
According to Morningstar Canada, the average management expense ratio (MER) for equity mutual funds is 2.28%, significantly higher than most developed markets such as the United States, Australia, and Netherlands2. To justify the management fee, these mutual funds are meant to be actively managed, meaning the portfolio manager performs an in-depth analysis of individual stocks in an attempt to outperform the market over the long-term, like the S&P 500. Passive management, on the other hand, simply mimics the performance of the underlying market or index. If a mutual fund has over 500 holdings in it, it is hardly convincing as being actively managed isn’t it?
It begs the question - why own both good and bad quality stocks when you could own just the ones with strong fundamentals and growth potential? And more importantly, why pay an actively managed fee for a passively managed portfolio?
1 IFIC Monthly Investment Fund Statistics – February 2020, Investment Funds Institute of Canada
2 Global Investor Experience Study: Fees and Expenses 2019, Morningstar
The views and opinions expressed are those of the author and may not necessarily be those of Aligned Capital Partners Inc. The content is for informational purposes only and not meant to be personalized investment advice.
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