Mutual Fund Morning

Return to Article

Mutual Fund Morning: Perfect 10s of Diversification

Richard Widows

"Diversification" is the first word investors considering mutual funds are likely to hear from a financial adviser. And it makes sense. "Don't put all your eggs in one basket" is one of the earliest lessons in economics for many of us.

So which are the most diversified mutual funds? There are a number of ways to gauge diversification. One would be to simply count the number of stocks in a fund's portfolio. The problem with this is that no matter how many stocks a fund holds, its true diversification is limited if they all have similar characteristics. For example, in the late 1990s, a fund loaded solely with tech start-ups would likely have met an unfortunate fate no matter how many of these stocks it held.

So a potentially more useful measure of a fund's diversification would be the number of distinct sectors represented in its holdings. Using that logic, TheStreet.com Ratings has studied the dispersion of sectors within open-end stock funds. These are:

• Basic industries
• Capital goods and technology
• Consumer cyclicals
• Consumer non-cyclicals
• Energy
• Finance
• Miscellaneous
• Non-U.S.
• Transportation
• Utilities

In order to identify the most sector-diversified mutual funds, we set the following stringent criteria:

• Each of the 10 sectors above must be represented in the equity portion of the fund's portfolio.
• Every sector must represent at least 3% of the fund's equity holdings, thus insuring that the sector's weighting is of sufficient mass to influence the fund's performance.
• No one sector should represent more than 30% of a fund's equity holdings, as that would indicate a level of concentration that wouldn't be consistent with the concept of broad diversification.

The funds passing these rigorous constraints appear in the accompanying table. Multiclass funds are listed as a single entity, since their holdings are identical.

'Perfect 10s' of Sector Diversification' Holdings of Between 3% & 30% in Each of 10 Major Equity Sectors

Click here for larger image.

Source: TheStreet.com Ratings

Among the fund families, the Janus Capital Group leads with five "perfect 10" funds on the adjoining table of sector diversification leaders, followed by investment industry giant Fidelity, with four.

But which of these funds is the most diversified? One way to answer that is to look at the percentage of equity held in a fund's biggest sector, which is shown in the table. If the percentage is high, it means the fund is somewhat concentrated in that sector and, by definition, not as broadly diversified as it might be. Conversely, if the percentage in a fund's largest sector is low, it implies a lack of concentration and, therefore, relatively high diversification.

For example, since membership in the "perfect 10s" of sector diversification requires portfolio equity representation of all 10 sectors, if the largest sector is 10%, then all the other sectors would also be 10%.

So by the measure of the lowest percentage representation of a fund's biggest sector, the Manning & Napier Pro-Blend Moderate Term (EXBAX) fund appears to be the most widely diversified, as measured by sector representation.

But even if a fund's largest sector holding is much more than 10%, there is still room for variance among its remaining sectors. A more precise measure of the "levelness" of fund's dispersion would be the standard deviation of the percentages of its sector totals.

A low standard deviation means the percentages of the fund's sector holdings are close together, while a high number means that they are more spread out and that a degree of sector concentration exists. So we computed the standard deviations in the percentage holdings of sectors for the funds, with the numbers appearing in the right-most column of the table.

And so by the standard-deviation test of sector holdings, the sector diversification champion is again the Manning & Napier Pro-Blend Moderate Term fund, with a standard deviation of sector holdings of only 3.68 percentage points.

In the standard deviation derby, the fund edged out its sibling Manning & Napier Pro-Blend Maximum Term Fund, which clocked a standard deviation of 3.75 percentage points. The two Manning & Napier funds were the only ones from the 'Perfect 10' group with standard deviations of less than 4.0 percentage points.

Besides capturing first place in diversification of its equity holdings, the Manning & Napier Pro-Blend Moderate Term Fund, as an asset-allocation fund, is further diversified in that a significant portion of its holdings are in fixed-income vehicles. In other words, it is diversified in types of investments as well as in the diversification of its equity sectors.

And what about the portfolio management of the sector diversity champ? It's a team, meaning diversification exists even in that aspect of the fund as well.