Hi Guys,
I am a long standing member of the DIY clan, sometimes successful, sometimes not so successful.
One lesson that I have learned is that an essential element for improving the odds for successful investing is keeping it as simple as possible.
I’m certainly not the Lone Ranger in that belief. Henry David Thoreau said: “Our life is frittered away by detail. Simplify, simplify.” Leonardo da Vinci proclaimed that “Simplicity is the ultimate sophistication”. Finally, Albert Einstein cautioned: “Everything should be made as simple as possible, but not simpler.” I choose to position myself on the shoulders of these giants, including the acknowledgement that simplification does reach a limit.
The bulk of MFO readers have reached a similar conclusion. I suppose that is the primary reason why we invest in the mutual fund/ETF universe because it is an enormous simplification in contrast to assembling a diverse portfolio of individual equity and fixed income holdings.
To answer DavidV’s question requires a fuller understanding of his commitment to either an actively managed or passively managed mutual fund philosophy. His example funds suggest an actively managed program, but most of us, perhaps DavidV too, deploy a mixed strategy. The answer partially depends on the response to this binary decision.
If the current commitment is towards an actively managed mutual fund sleeve, then a shorter group of active funds is more likely to deliver positive Alpha, excess returns relative to a benchmark.
That observation is a direct output from Monte Carlo studies recently completed by Rick Ferri and Allan Roth. It results from the fact that most active funds fail to outdistance relative benchmarks, so adding more of a less than
50 % likely outcome mathematically reduces the odds of outperformance on a cumulative basis.
Here are the Links to the Ferri study and a summary of the Roth simulations:
http://www.rickferri.com/WhitePaper.pdfhttp://www.forbes.com/2010/04/22/mutual-funds-etfs-active-management-personal-finance-indexer-ferri.htmlBoth studies demonstrate a dramatic falling of success probability (again defined as outshining an Index benchmark) as the number of active products are added to a portfolio. These results do not address the issue of the benefits of diversifying across asset classes, but rather show the shortcomings of adding extra active funds within a given group. Also, these studies did not explore the advantages of using a few screens, like lower expense ratios and lower trading frequency, to enhance the odds of selecting winning active fund managers. These tasks remain to be done.
On the other hand, there does not seem to be a downside disadvantage when adding passively managed funds to benefit from broad international diversification. Costs are minimized and the likelihood of market average outcomes are maximized.
The totally passive strategy minimizes stress levels, workload, and monitoring efforts. These are such attractive pluses that many investors, including even the outperformance zealots, include a mix of actively managed and Index-like products in their portfolios.
With a basic passive investment philosophy, a minimum of three Index holdings can grossly cover the waterfront. However, a more refined portfolio that includes between 7 and 10 Index holdings (REITs, small value oriented funds) can marginally enhance returns (order 2 %) while simultaneously, and most importantly, control risk by reducing portfolio volatility by perhaps 40 %. That reduction in volatility is particularly significant since it will encourage an investor to “stay the course” during stressful plunging markets.
To summarize: when choosing active fund positions within a category, more is definitely not better, and when selecting Index products, it doesn’t much matter except for the needed recognition that all Index products are NOT created equally.
I hope this posting is just a little helpful.
Best Regards.
