September 13, 2005

Less is better than more
Advisors should tighten up recommended funds

A lot has been written about how holding too many mutual funds can potentially kill portfolio performance. I've authored a couple of those pieces myself. But what many financial advisors have failed to realize is that this concept also extends to their overall client base or 'book of business'.

Group of seven

Ask any veteran financial advisor and she'll tell you that the key to keeping on top of the world of mutual funds is that she limits herself to selling funds from 5 to 7 providers. The advisor would argue that with 20 to 30 funds apiece, he has access to some 200 funds from which to choose for client portfolios. And surely that should be plenty for access to all asset classes and ample diversification.

On the surface, this makes sense. Indeed, my firm's recommended list of load mutual funds contains roughly ninety funds, with less than 1/3rd of those highlighted as "top picks". But I would argue that advisors should become much more focussed and make much bigger bets than they do currently.

Frequent trading, not the problem

If you count IFIC reporting mutual funds as representative of the fund industry, it's fair to say that investors have had disappointing performance. Using month end data for the 135 months (that's 11 years and 3 months) from November 1993 through December 2004, I estimate that investors in stock mutual funds have experienced annualized returns of about 5.25% per annum.

That's not exactly inspiring performance in a class where substantial risk has been realized at times. Old U.S. studies reveal similarly disappointing performance and they typically conclude that investors trade too frequently. But guess what? That's not the problem in Canada.

In fact, whether measured on a monthly or rolling year basis, the median holding period over the same 11-year period was just shy of seven years. It was less than six years on a rolling year basis until 1995. Holding periods have historically fallen briefly when swift declines occur but investors freeze in times when bear markets persist - as happened from 2000 to 2003.

I maintain that the problem lies in the bloated list of products pumped out by this industry. It's the same concept of so-called di-worsification, but on an aggregate level. Let's use the Canadian equity asset class to illustrate.

I've written previously about how holding just two larger cap Canadian funds can put portfolios on the path to underperformance. The idea is that Canada has only sixty large cap stocks, another sixty mid cap stocks, and more than a thousand smaller companies listed on the Toronto Stock Exchange. With Canadian stock funds holding at least 20 large cap holdings each, it doesn't take long before you're holding a big chunk of the TSX.

I get concerned once an individual holds more than two Canadian stock funds. But given the nearly 400 Canadian stock funds tracked by IFIC (as of the end of 2004), it's clear the industry - and in turn its end clients - have pretty full exposure to the TSX. That's not a bad thing in and of itself. But it is when you're paying a premium for active management. As you add more and more active managers (and funds), you reduce the potential for outperformance.

A 'book' as a portfolio

An advisor's book of business is a subset of the industry, but think of it as one big portfolio. Advisors using 5 to 7 fund companies will be picking Canadian stock funds from a universe of more than 90 mid and large cap Canadian stock funds.

Such a long list of funds is bound to result in underperformance of clients' Canadian equity exposure. So, advisors must further concentrate their chosen funds - more than they do currently.

Recall that each fund is already fairly well diversified, in most cases. List all of the Canadian equity funds in use for client accounts. If you go beyond a handful, you need to trim your personal recommended list.

My firm's recommended list highlights top picks - at most two selections for each asset class covered. The longer list helps advisors manage DSC and other similarly constrained assets until such constraints loosen. But the idea is that an advisor's list of recommended products should be very tight. Otherwise, what you end up with is some clients that do well and some that don't.

Ideally, advisors should know a manager well enough to make a bet on that manager. Make that firm or individual the 'go to' manager for a particular asset class. While that improves chances of underperformance, it is also the only way to have consistent performance across client accounts. It's also the only way to have a client base that outperforms, in aggregate.

The industry has given its end clients disappointing returns. If you want to replicate that disappointment, continue using several funds for each asset class. If you want clients to outperform, tighten up your personal recommended list.