Diversification Requirements: Why Mutual Funds Lose to the Market

by Darwin on February 26, 2012

It is commonly said that mutual fund managers can beat the market in one year, and maybe even two years. Over the long haul, however, any given mutual fund manager is certain to lose to the market, due to the higher-cost fee structure common with most mutual funds.

Other perspectives argue that mutual fund managers have little incentive to outperform. Given the marketing environment, it is better for the mutual fund manager to maintain performance that more or less equals that of the benchmark. That means investing the majority of a fund in the benchmark to be “close enough” every year. This also makes perfect sense, but given the egos on Wall Street, it doesn’t really seem to be that convincing.

So what if outperformance had nothing to do with fee structure or the fund’s marketing capacity? (This is a now commonly accepted mathematical finding following Nasim Taleb’s groundbreaking book Fooled By Randomness), but consider this additional cause:

Diversification Requirements Destroy an Edge

Mutual funds are governed by thousands of laws. Chief among them is the Investment Company Act of 1940 which sets the diversification requirements.

A mutual fund manager cannot:

  1. Own more than 10 percent of any one company.
  2. Invest more than 5 percent of the fund’s assets in a single holding.

These rules seem as though they’re for the betterment of everyone. Mutual fund companies never hold too large of a stake in one firm, which would allow it so much control that it could shift the balance in key decisions to parties not invested in the fund. A mutual fund manager with huge proxy voting power could easily shift influence for critical shareholder votes, and even install its own friendly associates on corporate boards.

The diversification rule also seems fair. The more diversification, the better for the investor – at least that’s what we’re led to believe.

Why Mutual Funds Underperform

These rules play heavily into the performance of any given fund. Here are just a few ways the diversification requirements place a hefty burden on managers looking to beat the market:

    1. Practical Indexing – Twenty stocks might as well be considered an index. Given that a mutual fund company must have at least 20 holdings by nature of the law, it is already fairly diversified to the point where the fund will begin to mimic the major market indexes. In this structure, the outperformers would necessarily have to be cut as the fund quickly runs over the 5% position limit.
    2. Small Cap Void – Mutual fund managers have to avoid small cap stocks to remain within the confines of the law. A mutual fund with $1 billion in assets could invest no more than $50 million in 20 different companies. This requires that every firm is also sized at $500 million in market cap or more, since fund managers can own no more than 10% of a single company. If you can invest only in mid and large cap stocks, it makes sense that you would perform in equity with an index like the S&P500 index.
    3. All Macro Plays – Mutual fund managers are required to be macro-theme investors. To place 10% of the fund into automotive stocks for a rebound, for example, a manager would have to purchase at least two companies. Basically, a fund manager is required to purchase both their perceived best investment and also their second best. Diversification obviously lowers returns. No rational investor would ever decide to invest in more stocks of lesser quality than fewer stocks of higher quality.
Further Reading:  Hereare some diversification strategies in places you might think you’d never find them:

Paying for Expertise and Getting Nothing in Return

Imagine if by law, full-service gas pumpers in Oregon were required to service every car with one-third unleaded, one-third premium, and one-third super premium gasoline. Imagine that football coaches were required to let every player rotate as quarterback, and every baseball coach were required to make every player a pitcher to diversify their risk.

Imagine if your doctor were required to give you a proportional amount of every drug so as not to make any unnecessary risks in diagnosing and treating any common injury or illness.

Such laws would require those having the expertise to be above-average in their particular profession to be merely average.

Would you blame the gas attendant, the coaches, or the doctors for their inability to outperform?

Written by JT, who blogs about finance and investing at MoneyMamba.

{ 9 comments… read them below or add one }

Darwin February 26, 2012 at 6:21 pm

Great points raised here JT. Aside from the “Fooled by Randomness” phenomena, forced diversification relegates a fund manager into market performance minus the fees over time, guaranteed sub-par performance. Occasionally, there’s a fund with some restrictions (not quite a hedge fund, but not a conventional mutual fund) where they’re allowed to employ some techniques like using options and derivatives and such to try to beat the market and/or provide non-correlated returns… but frankly, retail investors for the most part are chasing returns after reading the latest lame Kiplinger’s review of last year’s top mutual funds – without realizing that any future performance is completely…random. And sure to lose to the market over a long enough period of time.


JT February 27, 2012 at 2:19 pm

You know, I’ve never really believed investors were performance chasing.

There are quite a few funds with insane 10-year numbers in the US small cap stock category that have a mere pittance in assets. Maybe that’s just frictional – they aren’t highly advertised and perhaps not available in all accounts.

Or maybe it’s that investors tend to chase performance with asset classes (gold, for example) rather than managers. That’s probably more likely, and consistent with what I see from investors. It’s also the worst kind of performance chasing you could have.


Darwin February 27, 2012 at 11:07 pm

Have you ever check out a Kiplinger’s? It’s utterly mind-numbing. They just look at last year’s performance chart, write up a puff piece on the fund manager, his dog and his hobbies, some platitudes about his “strategy” and top holdings and call it “the fund to own in 2012”.


101 Centavos February 28, 2012 at 7:24 am

I could pass a fun afternoon ripping on the fluffy fluff that passes as serious journalism in Kiplinger’s or Money or Smart Money. The test is to go back 10 years ago, and see how those fund recommendations played out.


JT February 28, 2012 at 12:32 pm

Smart Money, Money and Kiplinger’s are too “personal” finance for me. I haven’t ever found reason to buy any of them. Smart Money I got for $1 for a year with a WSJ subscription, and even then I don’t think it was worth it. YMMV.

As for Kiplingers, I think I had a subscription wayyyy back in the day. I don’t have it now. I was probably too young to realize what was going on with their mutual fund recommendations, but if they do simply take the previous year’s best performers and make a recommendation on 1 year…wow!

AverageJoe February 28, 2012 at 12:16 pm

Awesome piece as usual, JT. My kind of discussion going on here, too.

I don’t get this line: “Mutual fund managers have to avoid small cap stocks to remain within the confines of the law.” Did I miss something? What law is this? Some have to avoid these to stay within the confines of the perspectus, but I don’t know of any law.

I had a friend who managed serious money (well, serious by my standards….$550M…not serious Wall Street money by any means) tell me that the goal WAS to be a leach. Just good enough in up years that they keep you and close enough to the index in down years that they’re glad they diversified.

Not really what we’re looking for, is it? I won’t start on pop magazine’s Top 10 Funds You Need to Own Now! pieces….


JT February 28, 2012 at 12:44 pm

Thanks, Average Joe.

As for staying within the confines of the law, I meant the diversification and ownership rules. Your friend who managed $550M would have to invest in at least 20 firms, which – in the worst case – is $27.5M a piece.

Since he cannot own more than 10% of any one company, a limited diversification would allow him to look at equities with a market cap of no less than $275M to avoid owning 10% of a firm. Not a big deal for amounts like $550M – that really is small in the fund space – but for funds with several billion, there’s no chance legally or for the purposes of practicality, that such a fund can get into the smaller securities.

What you said makes perfect sense to me. If I were a money-hungry mutual fund manager, I would put 70% of the fund in SPY and actively-manage the other 30%. As I tend to hold no more than 8 stocks in my own portfolio at any given time, I’m sure I would have the same desire to do so with other people’s money. Not legal of course – jail time doesn’t seem very fun – but you have to play by the rules!

Hedge funds are so much better to managers. No diversification rules, and real incentives for upside. Make a 25% return with a hedge fund and receive 2+6.25% of the fund for that year. Make a 25% return with a mutual fund and you get a flat percentage of assets, or if you work for a fund company, maybe a “small” $200k bonus on a $100+ million fund.

I want to get into portfolio management. Equity research is the way into such a position. The rules for money management are so unbelievably ridiculous that it’s almost better to stay in research, unless you start your own hedge fund. I’ll wait for all the future rich people I know from college and high school before launching a hedge fund. 😉


Invest It Wisely March 1, 2012 at 4:46 pm

Great post, JT, and interesting, did not know about these additional rules. Are hedge funds really the way for investors, though, or do the same long-term considerations of losing to the market also apply there?


JT March 1, 2012 at 6:24 pm

Hedge funds have their own problems, mostly that they are severely handicapped by marketing rules. Since the structure provides for very little transparency, and there are often only a few investors in each fund, it’s hard to accurately track the performance of any particular fund over a long period of time. I don’t know if there is any real, clear study into their long-run performance.

Warren Buffett’s initial partnerships were pretty much modern day hedge funds. Most importantly, from the early letters, he had almost zero real diversification, which is undoubtedly why he rocked the market for so many years.

From one letter: “We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”

I think he had as much as 30% of his fund in a single map company at one time.

Interestingly, even the best investor in the world still faces falling returns. Berkshire holds fewer companies than most mutual funds (I think it has partial or complete ownership of less than 30 companies), but as he’s diversified, his returns have only dropped. If you go back to his early returns, he was very easily pulling down 30-40% per year – one year almost hit 60% while the indexes were only up 8%.


Leave a Comment

{ 1 trackback }

Previous post:

Next post: