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Why is your portfolio underperforming the market?

Dilution increases costs while providing index-like returns.

Dan Hallett 5 March, 2007 | 2:00PM
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Many in the fund industry, including yours truly, have trumpeted the fact that investors' portfolios, in aggregate, aren't doing as well as the markets. Why the gap? Problems often cited include overlap of holdings and the tendency of investors to chase hot funds, but I don't think that there's as much merit in those causes as is widely believed. I'd put my money on portfolio dilution as the main culprit of investors' underperformance.

I have often cited investors' infatuation with hot funds or sectors as a source of underperformance. This is true of narrow-mandate funds like those investing in China, precious metals and the like. Star-chasing still happens, but in aggregate this is not the problem I was once convinced it was for Canadian mutual fund investors.

Poor timing indeed is a contributor to underperformance, but I'm not so sure it's the biggest contributor. Indeed, the average holding period of Canadian long-term mutual funds (all funds except money market) over the past 13 years is reasonably long at six to seven years. In fact, this asset-weighted average holding period has nearly doubled since 1993. And in past periods of significant market declines, mutual fund investors tended to trade less, not more.

Given these facts, is it plausible that mutual fund investors are making huge trading mistakes? I think not. Sure, the timing of purchases is often not great, but a sufficiently long holding period can diminish the impact of timing. So what's the problem?

Another cause of underperformance I've often heard people talk about is investment overlap -- essentially, having too many funds doing the same thing. I'm sure that I've expressed that opinion myself in the past, but that's also not quite right. Holding two funds that precisely overlap each other -- not only the same style but the same holdings -- poses no problem as long as the investor's overall portfolio exposure to the funds and the asset class is suitable. Rather it's where there is style and mandate similarity but without perfect overlap that portfolios run into trouble.

Admittedly this is something of a play on words, but the distinction between overlap and dilution is important. To some extent, holding two or more similarly managed funds holding like but not identical stocks (i.e. large cap Canadian) could be considered simply as an exercise in diversification, but it doesn't take long before portfolio dilution (or "di-worsification") kicks in. This is where the portfolio risks becoming more index-like but with active management fees. That will doom any portfolio to long-term underperformance.

The industry's bloated line-up of products is to blame. If we look at the entire fund industry as one gigantic portfolio, Canadians are holding hundreds and hundreds of unique funds just to invest in Canadian stocks. I would never recommend that any investor spread money among hundreds of funds -- particularly in such a small asset class. And I have opined in the past that at least 90% of funds are probably not worthy of investors' dollars. Accordingly, investors in aggregate are bound to underperform.

Diversification is a critical component of sound portfolio construction. Investors must strike the delicate balance of having sufficient diversification (to reduce reliance on any one stock) with the need to stay focused enough to make active management worth paying for. Dilution (or excessive diversification) can result in an expensive, index-like portfolio. Too focused a portfolio can incur too much risk (making success more uncertain).

Striking the right balance is key and it's admittedly far from a pure scientific exercise. While I can't give you the definitive answers, the above issues should be top of mind during the portfolio construction process.

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Dan Hallett

Dan Hallett  

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