Funds Can Be Too Close for Comfort


By Beth Piskora At Standard & Poor's, we advise investors who seek diversification by owning a number of mutual funds to make sure the funds' holdings aren't too similar. We believe investors who allocate resources not only to different kinds of assets (for example, stocks, bonds, and cash), but also to various subsets of each asset class, can increase their chances of achieving solid returns while minimizing volatility.

Many experts think diversification is one of the biggest benefits of mutual-fund investing (see BW Online, 7/26/04, "BusinessWeek Retirement Guide"). An investment of as little as $250 can buy exposure to hundreds of stocks. However, some funds are so similar in their holdings that investors who own two or more may get little additional diversification benefit. Also, since many fund investors also own individual stocks, they may be more exposed to one company's fortunes than is advisable.

Let's say an investor has shares in Microsoft (MSFT), as well as an S&P 500 index fund, a large-cap growth fund, and a technology fund. Since Microsoft is in the S&P 500, it would also be in the index fund and is a likely holding in the actively managed funds, making this investor's exposure to Microsoft potentially higher than he or she realized.

RESULT CORRELATION. Mutual funds are legally required to disclose their holdings periodically, and we think fund shareholders should compare these lists. If that sounds too time-consuming, www.overlap.com is a Web site that will do the work for you (a one-year subscription costs $165). "Funds that appear to be different are producing highly correlated results because they have similar market exposures," says Overlap.com founder Bill Chennault.

In particular, many actively managed domestic equity funds offer little added diversification for investors who already have an S&P 500 index fund as one of their core holdings.

Fidelity's giant Fidelity Magellan (FMAGX), which is closed to new investors but is still a popular choice in 401(k) plans, is often called a "closet" index fund -- a charge that portfolio manager Robert Stansky denies. However, Overlap.com analyzed Magellan's holdings vs. those of the Vanguard 500 Index/Inv fund (VFINX), which is a proxy for the S&P 500, and found a great deal of duplication. In fact, 57% of Magellan's holdings were also in the Vanguard fund at the end of March, according to Overlap.com.

SOME ALTERNATIVES. And it's not just that Magellan owns many of the stocks in the S&P 500. It also owns them in similar proportions. General Electric (GE), for example, makes up 3.27% of the S&P 500 and 3.43% of Magellan's assets. Pfizer (PFE) is 2.5% of the index and 2.47% of the fund.

Fidelity's flagship fund isn't the only one that has significant overlap with the S&P 500. Many of the largest actively managed domestic equity funds have too many of the same holdings as the index, in our view, to offer enough added diversification (see table below).

There are, however, some exceptions. Of the 19 biggest actively managed domestic equity funds in the table, six have little overlap with the benchmark. One is Fidelity Contrafund (FCNTX). This shouldn't come as a surprise, since it's deliberately contrarian in its investment choices. Another is Fidelity Low Priced Stock (FLPSX), which holds more small-cap and mid-cap stocks, not the large-caps that are more likely to be represented in the S&P 500 index. As a sector fund, Vanguard Health Care (VGHCX) also has little overlap with the index.

Fund/ticker % Overlap with the Vanguard 500 Index fund

Fidelity Magellan (FMAGX)

57

Fidelity Blue Chip Growth (FBGRX)

56

Fidelity Growth & Income (FGRIX)

56

American Century Ultra/Inv (TWCUX)

45

Washington Mutual Investors Fund/A (AWSHX)

41

Fidelity Equity Income (FEQIX)

40

Fidelity Growth Company (FDGRX)

38

Investment Company of America Fund/A (AIVSX)

36

Fidelity Dividend Growth (FDGFX)

35

Vanguard Windsor II/Inv (VWNFX)

34

Fundamental Investors Fund/A (ANCFX)

30

Growth Fund of America/A (AGTHX)

26

Vanguard Windsor/Inv (VWNDX)

25

Fidelity Contrafund (FCNTX)

17

Vanguard PRIMECAP (VPMCX)

17

Dodge & Cox Stock Fund (DODGX)

14

Davis New York Venture/A (NYVTX)

10

Vanguard Health Care (VGHCX)

8

Fidelity Low Priced Stock (FLPSX)

1

All data as of the end of 2003, except for:

Fidelity Magellan -- March, 2004

Fidelity Blue Chip Growth, Fidelity Growth & Income, Fidelity Equity Income, Fidelity Growth & Income, Fidelity Dividend Growth, Davis New York Venture, Vanguard Health Care, and Fidelity Low-Priced Stock -- January, 2004

American Century Ultra, Vanguard Windsor II, and Vanguard Windsor -- October, 2003

Fidelity Growth Company -- November, 2003

Vanguard Primecap -- February, 2004

Data: Overlap.com Piskora is senior editor of Standard & Poor's weekly investing newsletter, The Outlook


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