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
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
Clones, like clowns, hide their true identities behind makeup and
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).