How many funds make an ideal portfolio?

Most investors will find that more than 20 or 25 funds is way too many. Our head of personal finance Moira O'Neill looks at this common investing dilemma.

If you’re an ISA investor, here’s a dilemma you may not yet have considered.

It relates to an essential pillar of investing — that of diversification, the art of not putting all your eggs in one basket, famously dubbed “protection against ignorance” by investment guru Warren Buffett.

Diversification is common sense. By investing in a variety of assets you spread your investment risk and increase your exposure to more opportunities that could see your money grow. But in practice it throws up some difficulties.

Many seasoned investors are adamant that they can create a diversified portfolio of shares by buying holdings in 20-30 stock market-listed companies and that ordinary DIY investors can do so too.

The number is small enough to make the portfolio manageable — they call this “relatively concentrated” - but large enough to allow a wide spread of sectors, company sizes and regions.

It’s fine as a strategy if you know what you’re doing and have the time to do the monitoring and research required. But how does this approach to diversification translate for ISA investors who prefer to delegate investment decisions to the professionals, buying 20 or so collective investments such as funds, investment trusts and exchange traded funds (ETFs)?

Each fund, investment trust or ETF that you hold will invest in at least 20-30 stocks and maybe many more. If you hold 20 funds, you will be holding at least hundreds and maybe thousands of underlying stocks.

I call this the concentration conundrum. It may feel like a concentrated portfolio, but in terms of the underlying holdings across the portfolio you’re not concentrated at all.

It’s sensible to spread your risk between investment firms, the professionals that manage your money are human and can make errors. But most investors will find that more than 20 or 25 funds is way too many to keep track of — and it may not be necessary.

In our own interactive investor model growth and income portfolios, we believe that we can achieve enough diversification with between eight and ten funds. And that’s covering all the major asset classes, such as shares, bonds and commercial property, plus different stock markets around the world. Our method involves choosing one fund for each asset class.

Investors may be feeling very cautious. Some, after all, were trapped in star manager Neil Woodford’s fund or in property funds, and may not be willing to take much risk on fund managers. Nevertheless, if you had held Woodford as part of a balanced diversified portfolio, you probably wouldn’t be suffering a huge loss.

Think carefully about the maths of monitoring your portfolio. Once you have holdings that are worth 2% or less of your portfolio, they aren’t adding much value to your investment strategy. If you have a tail of funds that are only worth 1 per cent of the total ISA portfolio, this absolutely needs cutting back.

It’s worth doing an X-ray of your fund portfolio — where you look at its underlying stocks — to see where your main exposures lie. You may find that you have overlap between funds that makes your portfolio particularly bloated in one sector or company.

There are a few tools online that will help you do an X-ray and your Isa investment platform may have one too.

But you could also simply look at the top ten holdings in your funds to spot any overlap. I’m guessing UK dividend stocks will be present for many portfolios. The process may lead you to cut your number of funds.

Be realistic about the time demands of monitoring your chosen funds. Have you got enough time to monitor them properly?

You should really check in with your fund portfolio once or preferably twice a year to make sure that the asset allocation — the balance of the funds — is correct. At the same time, check for warning flags.

Has the manager moved, has the fund underperformed its benchmark or its peer group, has its strategy changed? It’s not a particularly onerous check but worth putting in your diary.

You could also risk suffering a bout of “di-worsification” where you pay extra for active management of your funds with the aim of beating average stock market performance, but in reality you create an expensive tracker fund that replicates market performance, or maybe slightly underperforms the market because of the fees.

If you have a UK focus, then don’t collect 10 UK funds — you’ll be replicating a small pool of shares and could just be constructing an expensive tracker fund.

There are many ways to think about structuring a fund portfolio and there’s no right and wrong. The key is to have a plan that works for you, your time commitment and your appetite for investment risk.

Have a picture of your end portfolio and work out how to get there, whether you’re investing £50 a month, have a lump sum to invest at the end of the tax year or have recently come into a windfall or bonus that you want to stash away.

Moira O’Neill is head of personal finance at Interactive Investor and a former winner of the Wincott Personal Finance Journalist of the Year award. @MoiraONeill.

This article was written for the Financial Times and published there on 11 March 2020.