How Many Fund Managers Are Too Many?

You know what they say about too many cooks. Now there’s some proof that the investment broth gets spoiled by overdoing diversification and plugging money into an ungainly number of funds. The more managers you have, the greater the odds your returns will be mediocre, at best.

This is one of those concepts that a lot of investors know. Northern Trust Asset Management, though, has quantified it and taken the notion apart for examination. Investors “simply weren’t getting paid for all the risks they were taking,” says Mike Hunstad, the firms head of quantitative strategies. The result, he finds, is “generally benchmark-like returns—at active management fees.”

In other words, you don’t do any better than an index like the S&P 500. But you pay more for the privilege: The average fee for an actively managed mutual fund in 2019 was 0.66%, according to research outfit Morningstar. Meanwhile, the fee for Vanguard 500, which tracks the index, was 0.14%, almost one-fifth that of the active funds. So you’re paying a lot more for little or no extra return.

Sure, diversification is one of those virtues right up there with daily toothbrushing and regular exercise. Who would want to be in 100% tech stocks when the category took a dive during the 2000 dot-com bust? No less an authority than Mark Twain inveighed against concentrating stocks in Pudd’nhead Wilson: “Put all your eggs in one basket and—WATCH THAT BASKET.” The trick is how to allocate your stock holdings. The most elementary division is 60% stocks and 40% bonds.

Then the question becomes how to translate that into actual purchases, and for most people that means mutual funds. Northern Trust’s study covers 64 institutional investors globally, who hold 200 equity portfolios with a total asset value of $200 billion. The study covers the mistakes of the pros, and so is applicable to individual investors.

The report divides the risk you take into two camps: compensated risk and uncompensated. The compensated kind concerns investing segments that have established track records. Take “high quality stocks”: Where companies have strong balance sheets, solid earnings and revenue growth, sterling brands and solid management. They usually do well over time.

Like, and this is our example, Domino’s Pizza. With those advantages mostly in hand (the company has added a lot of debt, although that’s somewhat offset by a decent cash stash), the food chain saw its stock climb 38% annually over the past decade, far outpacing the S&P 500’s 12% showing.

The uncompensated risks are things that are less easy to quantify, such as foreign exchange for multinationals, over- or underweighting a sector, too much focus in one country or just very expensive share prices. Here, as the study explains, you “are not getting paid for the risks taken.”

While Tesla stock (our example, again) has been on a tear this year, more than tripling, it carries an enormous price/earnings ratio of 742. Despite rosy scenarios from some analysts about its future as an independent electric vehicle maker, is the stock really worth that much? Could General Motors or any of the other mega-corporations in the EV arena knock it out at some point? Hard to put a number of that.

So the question comes down to manager selection. All too often, it seems, the more managers you add, the greater your odds of running into trouble. Northern Trust calculates that 55% of the portfolios it surveyed have “style conflicts.”

That’s where you sign up opposing funds that cancel each other out. For instance, the report says, if you hold the Russell 1000 value index and the Russell 1000 growth index, you get the performance of the overall Russell 1000, but are paying higher fees because you own those two funds, instead of the mother ship.

If you have less than five managers, your uncompensated risk amounts to 43% of overall risk, according to Northern Trust. But if you have more than 10, it rises to 52%.

And then comes the timing problem. Often, Northern Trust notes, fund managers get hired because they burnt up the turf over the past year. That’s a recipe for investor disappointment. The good market year of 2017, with the S&P 500 up 21.6%, led to a lot of the year’s stars getting hired. Oops: 2018 was a negative year. The stars didn’t deliver as well. As the study finds, investors were “ultimately left dealing with the lackluster performance that followed.”

Best advice that we put together after reading this study: When looking for funds, find active managers with good long-term records and a minimum of lopsided exposure to uncompensated risk.