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The diversification buffet can leave you feeling queasy

Investors having their fingers in too many pies leads to a portfolio resembling an index fund.

Finbarr O’Reilly/REUTERS

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Diversification is often said to be the only free lunch in investing. Spreading your eggs among several baskets can lower your risk while maintaining, or even boosting, your returns.

However, for many investors who own mutual funds, the diversification buffet can lead to a bad case of indigestion.

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One problem is overindulgence. People assume that since diversifying among stocks and bonds is a good thing, more must be better.

Not so. It's possible to diversify too much and wind up with an expensive, underperforming portfolio as a result.

"A while ago I had a couple visit me for a second opinion on their portfolio," says Warren MacKenzie, co-founder of Weigh House Investor Services in Toronto. "What I saw was rather shocking. They had about $4-million in 80 mutual funds."

It's the type of situation that Mr. MacKenzie, who specializes in reviewing portfolios, sees too often. The problem with having so many funds is that an investor winds up owning pretty well all the securities in the market index. As a result, his or her results, before fees, tend to average out to the market return. That makes diversification a costly meal – or more precisely, an expensive index fund.

"An investor would be better off owning an exchange-traded fund that tracks the market index," argues Mr. MacKenzie. "It achieves the same result as all the mutual funds, but with a much lower management fee. For stocks, the ETF will often have an annual management fee under 0.2 per cent, compared to more than 2 per cent for mutual funds."

Those higher fees drive down your returns without providing any benefit. And the sheer profusion of funds in your portfolio can make it hard to figure out how much you have invested in stocks and how much in bonds – a key question for people who target a certain mix, or asset allocation.

What causes a portfolio to become overly diversified? Many investors have their accounts spread over several institutions. It's difficult for these investors and their advisers to keep tabs on everything.

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Other times the problem arises because investors get caught up in what's fashionable. One year it might be technology stocks, the next year income trusts, then life-cycle funds. People buy whatever is hot while continuing to hang onto their existing funds because of inertia or fear of redemption fees.

The current fashion is income products, according to Tom Bradley, president and co-founder of Steadyhand Investment Funds, based in Toronto. As a result of today's search for yield and safety, "it's now common to see portfolios with multiple monthly income funds, a few dividend funds and a variety of bond products," he said.

Too much diversification is not just a problem for portfolios, it's also a flaw with many individual funds.

Investors choose to pay more to invest in actively managed funds because they believe a manager can do better than the market. But a fund that holds too broad a portfolio can wind up replicating the market index.

This can happen because a fund has attracted a huge inflow of deposits and needs to put all that money to work. In other cases, it occurs because a fund has decided to play it safe and avoid bets that could cause it to lag the market.

Whatever the motivation, funds that hug the index without declaring that intention are called "closet indexers." They're needlessly expensive alternatives to true index funds.

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"If the client's overall portfolio looks like an index fund, then the fee should reflect that," declares Mr. Bradley. "On the other hand, if they are paying a premier fee for experience and expertise, they should have a portfolio that's focused on fewer securities."

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