Put your portfolio on a diet
Many investors, it seems, can't get enough mutual funds. They collect them like stamps, autographs, or pieces of string. They may not know why they bought them, and they might not have added any money to some of them since they bought them.
But how many is too many?
While there is no firm figure, most experts say 20 funds is almost certainly excessive. With that many, the investor probably has at least two that cover the same territory. Why pay the fees to own, say, two large- company growth funds when one will do?
"Twenty funds is way too many, even if you have substantial wealth," says Beth Gamel a financial planner with Pillar Financial Advisors in Waltham, Mass. A large number of funds not only risks overlap, it also can reduce the impact of some funds, Ms. Gamel says. "If you have very little money in one fund," she asks, "what kind of impact can it have on your portfolio's performance?"
On the other hand, "you can own just four funds, but if they do the same thing, you could have too many," says Emily Hall, a senior analyst with Morningstar Inc., in Chicago. For example, she says, people may have two funds that invest in large-company, blue-chip stocks. A glance through the latest shareholder report will show overlap, with many of the same stocks in the top 10 to 15 holdings of both funds.
Investors loaded up on funds during the stock market boom in the 1990s, when many funds were reporting spectacular returns, says Harold Evensky, a financial planner in Coral Gables, Fla. These funds received a lot of publicity or were heavily promoted by fund companies, and investors bought them without eliminating funds they already owned.
That didn't hurt their portfolios too much at the time, Mr. Evensky says, because the market's strong performance helped hide the added expenses. Now, it's a different situation. "We believe equity returns will be modest over the next decade, so there's too much cost involved in having too many funds," he says. "We spent a whole year changing our clients' portfolios because of that belief."
So, what's the right number of funds and how do you get there if you have too many? Experts' opinions vary, but six to 10 seems about right, they agree. For example, Gamel says, a portfolio with nine funds might include a taxable and a tax-free bond fund, a large-company growth fund, a large-company value fund, a small- company growth fund, a small-company value fund, a couple of international funds, and a money-market fund.
Investors looking for funds to sell should line up all their holdings according to their categories, such as large-company value and small-company growth, Ms. Hall says. "Ask yourself, 'Do I own too many funds that are similar in nature?' That will help you pare the bad funds or the underperformers."
Then, she says, look for "problem children," such as funds with above-average expenses (this information can be found in the fund's prospectus and on websites such as Morningstar's), funds that had a recent manager change, or funds whose parent companies were caught up in the recent fund-trading scandals.
The ones that are kept, she says, should have a combination of experienced management, a predictable strategy, low expenses, and a record of good performance over a few market cycles.
Other factors like sales charges and taxes need to be taken into account. If the funds were bought through a broker, the investor may not have owned them long enough to avoid any deferred sales charges, or back-end "loads." These charges often start at 5 or 6 percent of assets the first year and decrease to zero after five or six years. So if an investor has owned the fund for only a few years, it may not have gained enough to offset these charges. These funds may have to be kept a few more years.
Then, there is the matter of taxes. If the funds are held in a tax-deferred account like an individual retirement account, taxes are not an issue. As long as money is not withdrawn from the IRA, no taxes have to be paid when funds are sold.
In a taxable account, however, taxes may be an issue. "If you start with 40 funds and sell 20, you could have a pretty big tax bill if those funds have had big gains," Morningstar's Hall says. For example, depending on how it was managed by the fund company, one fund may have racked up very large capital gains during the time the investor owned it. If this fund is performing well, it may be the one to keep, she explains. On the other hand, if funds being sold have lost money, those losses can be used to offset gains from other sales and up to $3,000 of ordinary income.
Evensky, on the other hand, takes a simpler approach: "If you have 30 funds, sell the extra 20 or so all at once," he says. "If you made money on these funds, you're going to pay the tax eventually anyway, so you might as well get it out of the way."