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Diversification's fine, but only up to a point

If you're a seasoned and scarred veteran of mutual fund investing, you've heard about the perils of putting all your eggs in one basket. Put them in many baskets and you'll face less risk, the conventional wisdom goes.

In the ivory towers of academe, it's called diversification, and it's backed by a convincing rear guard of math and statistics.

If you really wanted to, you could find an egghead to walk you through the equations that prove diversification reduces risk.

That's the theory, anyway. In practice, there are dissenters. If superlative stock investors exist, after all, they'd buy only the handful of shares that promise to produce the biggest returns. But assume the theory is true. Can there be too much of a good thing?

Of course. The authorities, such as they are, used to say that most of the benefits of diversifying a portfolio come from the first 20 stocks or so. That's becoming a source of debate these days. Some studies are beginning to suggest that that's more of a bull market statistic; that in a bear market, you need more stocks to lower your risk.

But at any rate, when you travel the road to diversification, you soon come to a point of diminishing returns. The earliest stabs at it give the greatest results. Subsequent attempts lower the effect, and in a managed portfolio, cost and effort (it's not easy to find stocks that both diversify a big portfolio and have appealing prospects) help to define a line that's not worth crossing.

In other words, an equity mutual fund with, say, 30 stock holdings should be enough to spread the risk. So why do so many investors own several Canadian equity funds?

It probably could be demonstrated that adding a second fund to your portfolio could also add some risk-reducing benefits, but only if you were adding different stocks. The sad fact is that big funds angling in a small pond such as the Toronto Stock Exchange are going to reel in the same fish.

Pick a random sample of five of the top 10 Canadian equity funds and you'll see for yourself.

The same names appear over and over again. Of the five funds I looked at, the top 10 holdings comprised 35 stocks. Seven of these were owned by three or more of the funds.

That's far from scientific, and it ignores the weightings of these holdings, which is important to the diversification arithmetic. But on the other hand, that's only the top 10 holdings; if you could look at all of them, you'd probably find that most big Canadian equity funds are already well diversified and, furthermore, very similar in terms of holdings. Combining three, four or even five of them, as many investors do, adds no value.

It doesn't cost anything, either, so you might say who cares? But you should. Besides diversification, mutual fund investors also know that the median equity manager doesn't beat the index after all the fees. That's usually held up as a good reason not to buy a mutual fund; it should be held up as a good reason not to buy a fund run by an average manager.

Given the median performance statistic just cited, it's clear that more than half of the managers don't beat the index. Very few do, in fact, but the point is that a select group can over time. If you're going to own mutual funds, you have to find them or you're wasting your money.

But how can you do that if you're fixated on diversifying by buying a handful of the funds in the group? You can't.

Most of the holdings in Canadian equity funds are TSX 60 stocks.

If you want the performance you're paying for, you have to find the best manager. Otherwise, buy the large-capitalization market and be fully diversified -- with no hope of beating the index.

© 2007 The Globe and Mail. All rights reserved.

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