How Many Funds Do I Need In My Portfolio?

Perhaps for those who are into the sport of Market Timing and Tactical Asset Allocation ( which IMHO is another synonym for Market Timing ) or have short/medium term horizons and/or sophisticated strategies ( assuming they have a proven track record of success ), having more than 5 or 10 or even 20 Funds/ETFs could be profitable; but for the majority of investors who invest passively or quasi-passively through Funds or ETFs and whose horizon is Long Term with a Bogle ( B&H ) or quasi-Bogle style strategy with rebalancing, reinvestment of dividends, savings and averaging down ( either by value or price ), the truth is that a couple of low costs, widely diversified Index Funds/ETFs can do a better job than most combinations of different financial products in Equities.

If I am a person who already has a main source of income and who only uses the Stock Exchange as a means to preserve and grow my savings to improve income during my retirement, then most of my time and effort must be dedicated to securing and growing that main source of income because that source is what will provide me with the necessary flows to invest and increase my savings for retirement. Therefore, the subject of savings and investment, although it is important and we must know them well, should not take up too much time nor should it cause worries and unnecessary stress that puts the performance and certainty of our main source of income at risk… This is one of the purposes of this post, to simplify the diversification of our Equity Funds/ETFs so that with minimal effort ( this does not mean zero effort ) we obtain good results and thus spend more time increasing our main money flows, either with our jobs, with a franchise or with a company or freelance. Another of the objectives of the post is to reduce the commissions that we sometimes pay for being over-diversified and having many versions of the same fund or ETF with very similar components or that behave the same, which reduces our returns doubly, due to the number of Funds. /ETFs and for their commissions.

Methodology

To answer the question in the title I have created portfolios that contain from 2 Funds to 21 Funds ( 20 portfolios ) with equal weights and rebalanced annually. For each of those portfolios I have calculated the combinations of 93 different MSCI indices, combined by Capitalization, Style, and Regions; so there is almost everything, from Smallcap Value Latam exBrazil to Eastern Europe Large+Mid Growth.

Since making all combinations is almost impossible due to the dimensions ( eg: 93C 10=8.079e+12* ), then I have used a sufficiently large and random sample of combinations to be statistically significant. Each sample of each portfolio contains approximately 4 thousand combinations, that is, in total I have calculated a little more than 80 thousand combinations; but not only that, I have also repeated the same experiment calculating the average rolling returns ( Rolling Returns ) with monthly iterations for 1,3,5,7,10 and 15 years.

biases

Like any other study or experiment, this one too has biases. Some that I have recognized are:

• The results are from a sample, not a census.
• I have only considered portfolios with equal weights.
• MSCI indices are capitalization-weighted.
• The future will not be the same as the past, nor does past performance guarantee future performance.
• In investments, averages are rarely met, they are rather oscillations between extremes.
• Thirty years ago or even 10 years ago, there were still no retail products that replicated many of the indices I have used.
• I have only used indices by capitalization, region, and style ( Value&Growth ), so I have left out many other geographic and factor combinations such as dividends, quality, momentum, etc.
• Unfortunately, we only have a Financial History and it is very very short, therefore any conclusion will remain tentative, a mere theory.
• Due to a large number of combinations, the average return may have smoothed out and hidden several outliers, both positive and negative.
• Of the 93 MSCI indices, 41 correspond to Emerging, which means that the remaining 56% corresponds to Developed. This could create a bias in favor of the latter.
• Some data is from 1970, especially for Developed, but for many Emerging the data is from 95, 98, 99, or even 2003 and 2008. Therefore the tables for 7, 10, and 15 years Rolling Returns leave out the indices with a little history.

Data Source: MSCI with own calculations. Amounts are denominated in USD. They include dividends, but do not include commissions or taxes.

After just over 480,000 combinations for different time ranges and different portfolios, the table above summarizes the results found. DM+EM means a portfolio comprised of only two Funds, Developed and Emerging Large and Mid-Cap. The column that says “ MAXDD ” refers to the maximum DrawDown that was within the corresponding portfolio and for the indicated time range, that is if we had had the terrible luck of choosing the worst funds and keeping them during the period where they had their worst performance. The “ MAX Gain ” column” corresponds to the best compound annual return that some combination had during the indicated period and for the corresponding portfolio. The last column is the average of the average compound annual yield of all the combinations of that portfolio and already includes dividends.

We can see that over the 1-year and 3-year time frames, the average returns for all portfolios exceed the DM+EM return, but not by much. This means that if we add frictional costs and commissions, then the difference is not significant, or at least it is not for an investor like the one I have described above. Moreover, a portfolio with 6 or 10 Funds could be giving average net returns equal to or below a simple diversification of two Funds such as that of DM+EM, because remember that the Funds and ETFs charge their commissions on the total assets managed and not only about earnings. I am also making comparisons against the simplest and most well-known combination, Developed and Emerging, I haven’t even chosen the Value style, which is proven to give better performance.

For longer periods ( remember that they are rolling time ranges: rolling ) that small difference disappears and even our simple and boring portfolio for dummies ( DM+EM ) begins to outperform the average portfolio of other portfolios that contain so many combinations and variety. Funds that you can imagine.

Maybe the underappreciated and old-fashioned DM+EM portfolio doesn’t hit 150% 1yr Rolling or 40% 7yr Rolling, but I don’t need my portfolio to hit, because those surprises can be positive but also negative. They also imply to be guessing the future. For example, to obtain the 196.45% average compound annual rate, we would have had to buy the BRICS+EM Europe Smallcap Value on the last day of February 2009. Or to get 193.75% we would have had to buy those two plus EM Latam Smallcap Value. Now please tell me, who is the smartass who not only has the aim to buy so close to the ground but also has the excellent judgment to buy the combinations that would yield the best returns in a year? The same goes for all other cases with spectacular returns in any of the periods. There is no clear pattern of who the next winners will be or if those winners will be winners again in the future. If we had bought that same combination at the bottom of the summer of 2011 we would have had a return one year later of -12.67%. Sometimes it is the cheapest and/or most hated ones that become the winners; sometimes they are the most expensive and popular.

The truth is that in the long term and for the average investor on foot, a great variety of Funds or ETFs is not necessary to obtain decent results. We don’t need to be trading in our boring old Fund/ETF mix for the new hot one with the superstar manager. Nor do we need to jump from one Fund to another chasing the excellent returns of the past 5 or 10 years. It is not necessary to search and search through the thousands of Funds and categories for that exotic Fund/ETF that nobody knows about and seems to be a “gem”.

The average investor who invests his savings with horizons of more than 10 years and who periodically contributes his savings, reinvests his dividends and rebalances, does not need complicated portfolios or change the weighting of his Funds/ETFs according to the whims of the market, the news or adviser recommendations. A simple DM+EM is resilient and robust enough to give good results, as long as you are patient and disciplined and don’t undersell. Sure, and that your portfolio is complemented with RF and other assets.

Trying to seek greater exposure to certain specific market niches or wanting to have a fund that covers every little corner, can result in pursuing strategies that have already reached the climax of their cycle and/or in the dilution of returns, not only because of the number of Funds contracted but by the commissions and frictional costs that we must pay to each one. That is why sometimes it is good to see the commissions in absolute and not relative terms, that is, instead of seeing the percentage that they charge me, it is better to see how many euros I am paying in total and compare that amount with the profit obtained. So you will realize that sometimes we are paying more than 10% in commissions on earnings and that way we will not get very far

Forming a portfolio of Funds or ETFs does not mean accumulating all colors and flavors. We are not in the schoolyard collecting stickers. Sometimes, mistakenly, we focus our attention on the spectacular performance that one of our Funds/ETFs in our portfolio is having and we think we are geniuses for having bought it, but what really happens is that this spectacular return is diluted because it is weighting in our portfolio is not very large and/or because we have too many Funds ( or many versions of the same Fund ) that are reducing our returns through costs and duplications of each other.

The name DM+EM sounds boring and it is not a popular topic with the friends of the bar or the Forum, nor can you boast of your extensive knowledge and the wide variety of Funds that you know, but let us not be fooled by Funds or ETFs with names bombastic and sophisticated ones like Enhanced Pure Beta Value Tactical Alpha Momentum Growth Mega Quality Fund. They could be an excellent topic of conversation and everyone will look at us saying – that guy is a crack how he knows about this –, but in investments and more in investments of our savings the least we need is the applause, the popular or what is Fashion.

Yes, I have also made the mistake of the previous paragraph wanting to look for sophisticated, new, and little-known ETFs. I have also made the mistake of having too many in my portfolio Margrave told me one day that my portfolio looked like Noah’s Ark, but I have rectified it. The good thing is that Bull Market in recent years has allowed my mistakes not to cost money because almost everything has gone up. In some bets, I won and in others, I lost and in the end, the result of my active portfolio of Funds and ETFs have not been too different ( just 300bps up without counting taxes ) than if I had bought an index fund ( perhaps inclined to dividends ).). And that I am not taking into account all the time, study, and effort I made. Over diversification is always harmful, but it is worse in Funds and ETFs than in stocks, because in the former we have to pay annual commissions.

For those who have little time, interest, or desire to dive into this world and dedicate many hours to study and analyze it, or who prefer to spend their time on things that they like the most and that will make their main source of income growth, then the most recommended is that they are not buying as many funds, or that they are changing their weights too often. Perhaps diversifying by Manager is good advice to reduce the catastrophic risk of the institution collapsing. It is not only to diversify the securities, but also the institutions that guard and/or manage them.

Conclusion

We don’t need to have a portfolio of Funds or ETFs weighted by popularity, chasing terrific returns and past trends, or prone to guessing which asset class will be the winner next year. Don’t focus on spectacular returns, most investors don’t even get the return of the index. The only thing we need is resilience and robustness that increase the chances of reaching our destination without losing everything along the way, or as Bogle said: Forget the needle, buy the haystack and accumulate.

And now, what are the possible Funds and/or ETFs that can form this type of portfolio? In the next post, I will talk about them.

I want to thank Professor Javier Nogales for his advice and corrections. Any errors and opinions will remain solely my fault and responsibility.

How to create an ETF portfolio

Once we are clear about what ETFs are and where they can be purchased, it is also important that we are aware of what type of ETF portfolio we want to create. This will depend on our investor profile and our needs.