Streamlining is often at the top of my list when I work on Portfolio Makeovers each year. Most investors end up with needlessly complex portfolios, so one of my main goals for when I embark on a makeover is to skinny down an unwieldy list of holdings to a group of names that provides a lot of diversification but is simpler to oversee.
First on the chopping block? Sector- and region-specific funds. If an investor already has high-quality, well-diversified domestic- and international-stock holdings, these more specialized funds often duplicate exposures that are in the portfolio already. Layering them on top of a diversified list of holdings can add additional risk by supersizing exposures to individual regions and sectors, and often increases the portfolios' overall expenses, too. Because they're typically smaller than diversified domestic- and foreign-stock funds, sector- and region-specific funds usually have higher costs. Finally, investors' track records of using specialized funds well is poor. Because of their higher volatility, investors in aggregate have demonstrated a pattern of buying high and selling low.
Yet even as sector and regional funds are the easy targets when it comes to duplicative holdings, other positions might not be as obviously redundant, even for savvy investors who are plugged into the overlap issue. You may have good reason to want increased exposure to certain areas, beyond what you're already getting with your diversified equity funds, either because you'd like to make a short-term tactical play or because you'd like to emphasize a given area of the market long term. But if you already have a well-diversified portfolio and are considering adding to a niche category, pause to ask yourself whether your current exposure is adequate. Morningstar's Instant X-Ray tool and Portfolio X-Ray provide a valuable way to assess your overall exposures; you can also see your portfolio's exposures compared with that of the S&P 500 to help gauge the reasonableness of those weightings.
Here are three key categories where it's wise to ask yourself: Do I really need this?
Emerging-Markets Equity Funds
Despite the recent slowdown in key markets such as China, emerging markets are apt to provide much of the globe's economic growth in the decades ahead, and they may also be attractively valued right now relative to developed markets. Performance has been disappointing during the past few years, but investors have still shoveled $35 billion in new assets into emerging-markets funds during the past year.
Yet despite emerging markets' intuitively appealing fundamentals, I'd argue that most investors probably don't need to own a dedicated emerging-markets vehicle. Unless your core international holdings focus strictly on developed markets--and that's certainly the case if you own a fund that tracks the all-developed MSCI EAFE index--it's a good bet that your portfolio already has a decent-sized dose of emerging markets. Funds that track total international-stock market indexes have about 18% in emerging markets (depending on the index), and many widely held diversified foreign-stock funds hold more than that. The Silver-rated T. Rowe Price International Stock (PRITX) and Columbia Acorn International (ACINX), for example, recently had upward of 20% in emerging markets. If you're adding a dedicated emerging-markets fund because you think the markets are attractive, it's highly possible that one of your active fund managers is doing the same.
Of course, not all diversified foreign-stock funds have significant exposure to emerging markets, and some investors like to maintain separate holdings dedicated to developed and developing markets so they can exercise some oversight over the respective weightings. It's not unreasonable to consider boosting your emerging-markets position when prices are down. But unless you think you possess some particular insight into emerging markets, you're probably better off leaving the developed/developing decision-making to a pro or sticking close to a foreign-stock index's weighting.
Real Estate Funds
In contrast with funds that focus on sectors such as technology or retail stocks, the notion of holding a separate real estate fund has typically received more support among well-informed investors. After all, real estate securities have typically been considered a distinct asset class because they have different characteristics than other common stocks: They must pay out the bulk of their income to shareholders, and that buffer means they have sometimes exhibited a different performance pattern than other equities. (That wasn't the case during the most recent financial crisis, however, when real estate assets of all stripes were badly beaten down.) REITs are often touted for their inflation-fighting characteristics, as well, because landlords can more readily raise rents when the economy is booming and inflation is on the rise.
Despite those positive attributes, however, a distinct real estate fund is usually an unnecessary addition to a portfolio. The reason is that REITs are reasonably well-represented in many diversified domestic-stock funds. Total stock market index funds currently have a 3.5% weighting in the sector; funds tracking the small-cap Russell 2000 and Russell 2000 Value stake 8.1% and 12.6%, respectively, in REITs. Thus, if you're tilting your portfolio to capitalize on small-cap value stocks' historic outperformance (the so-called Fama-French effect), you're probably also inadvertently emphasizing real estate securities.
Individual Blue-Chip Stocks
Say what? Large-cap stocks make up the majority of the world's market value, so it's only logical that they should dominate our portfolios' equity holdings, too. And it's also natural that many investors gravitate to blue-chip names when selecting individual stocks for their portfolios. Individual investors are apt to have some familiarity with well-known, big-cap companies from their daily lives, and research on such firms is often more readily available than is the case for the market's small fry.
That said, such names are also apt to dominate an investor's mutual fund holdings, too, so you might find out that you already have ample exposure to those companies. Alternatively--and this gets pretty messy--you may not have exposure to a given company, but that's because your managers are actively avoiding it. By adding your own position in the company's stock, you could inadvertently undermine your managers' intentions.
Of course, even if you don't buy individual blue-chip stocks and stick with funds instead, there's no guarantee that you won't end up with some weird and unintended bets on individual stocks. For example, running Stock Intersection (in the X-Ray view of Morningstar's Portfolio Manager tool) on my own portfolio recently, I identified a freakishly large weighting in DirecTV (DTV), the apparent result of enthusiasm for the stock from my Longleaf Partners (LLPFX), Oakmark Select (OAKLX), and Vanguard Primecap Core (VPCCX) holdings. The satellite TV provider currently has a Morningstar Rating for stocks of 1 star, which gives me pause, but I've decided to let the chips fall where they may because I like my managers. That said, it's worth using our Stock Intersection function (found in the X-Ray view of our Portfolio Manager tool) to make sure you're comfortable with your portfolio's weightings in specific stocks.
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