Send in the Clones

By DAVID MOON, Moon Capital Management
May 29, 2005


Several weeks ago, I was reviewing the investments of a new client. He is intelligent, well-read and investment savvy. Too well-read, in fact. For years, his advisors and brokers recommended diversification and long-term holding periods. He listened. As he accumulated more money, he bought things and never sold them. He was a collector, not an investor. What he didn't realize was that most of the mutual funds he bought to provide diversification owned many of the same stocks. In fact, they were invested in groups of stocks that acted, if not even looked, an awful lot like the S&P 500.

Send in the clones.

The Wall Street Journal recently published an article recommending that investors review their portfolios for funds with significant overlap of holdings. Unless you want to read the annual and quarterly fund reports, it's not an easy task.

An easier way to determine if you own a bunch of mutual funds with the same practical portfolio is to look at the patterns of the returns of the funds. Most financial websites provide an 'R2' statistic for all mutual funds. R2 (pronounced 'R-squared') is a measure of the percentage of the change in a dependant variable that can be explained by a change in an independent variable. Specifically, the R2 of a mutual fund tells us how much of that fund's historic return can be statistically explained by the S&P 500 return. If the R2 of a fund is 100, it's return is fully explained by the return of the S&P 500. The manager is adding no value or additional diversification. As the R2 of a fund approaches 100, the fund is more like an index fund masquerading as something else.

Some popular funds have surprisingly high R2s.

Four popular funds from the American Funds family - each with different stated investment strategies - have R2s greater than 90. Not only does Merrill Lynch offer balanced and value funds each with an R2 greater than 90, they even have a global allocation fund with an R2 of 91. The S&P 500 explains 91 percent of the three-year price movement in this 'global' allocation fund. So much for global diversification. With an R2 of 99, the Fidelity Magellan fund is a practical index fund. Interestingly, both the SEI Large Cap Growth and Large Cap Value funds sport R2s of 93 or more.

It shouldn't be a surprise that these large funds would have similar portfolios. Behemoth funds can only buy the largest, most liquid, most popular stocks. The result is that they end up owning the same 100 of the largest S&P 500 stocks. These 100 stocks comprise 66 percent of the market capitalization of the S&P 500, so the returns of these funds are going to be pretty darn close.

Once a fund company has guaranteed that the returns of its largest and most profitable funds won't differ much from the market averages, its only remaining job is marketing, not investing. Investors, thinking they are wisely diversifying their portfolios, end up with a collection of funds, many of which duplicate an index that can be purchased a lot less expensively.

Clones, like clowns, hide their true identities behind makeup and marketing.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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