One may be the loneliest number, but for skittish investors it may provide some much-needed solace.We're talking, of course, about a one-fund portfolio. You already know that owning too many mutual funds is at best redundant, at worst a costly drag on your returns. There's virtually no reason to own more than eight funds, and many investors need far fewer. "Some smaller investors -- such as those with portfolios less than $200,000 -- could certainly do with just one equity and one bond fund," says Ed Osborn, a principal with the portfolio management firm Bingham, Osborn & Scarborough. But investors tempted to make do with just one or two funds should know the risks. "For the majority of investors, it makes much more sense to split their assets appropriately," says Larry Swedroe, a financial planner and author of Rational Investing in Irrational Times. Fixed-income funds should be in a tax-deferred account, and equities should be held in a taxable account." Bonds that pay out taxable interest are best held in a tax-deferred account (like an IRA) so investors avoid the tax until they withdraw from the account. Holding equities in a tax-deferred account, though, means you give up the ability to pay the lower capital gains tax rate when you sell your holdings, since all tax is deferred until withdrawal, at which point it's all taxed at the higher ordinary income tax rate, rather than the capital gains tax rate. But for investors who have their entire portfolio in one (presumably retirement) account and really can't bear the thought of taking an active role in determining their investments, some of these funds might help. "The biggest determining factor as to whether an investor should go into one of these funds is how much time they want to dedicate to making investment decisions," says Morningstar Mutual Fund Analyst Langdon Healy. "That's the general profile for these funds."
Now, there's no one ideal fund for everyone, but if you think you're suited to the single-fund portfolio theory, there are a few good bets. All-you-need funds can be split into three categories: broad-market index funds, funds of funds and lifecycle funds. We¿ll go over each category and highlight a few picks.
Index FundsMost planners will reflexively say that investors should break their equity investments into size (large or small-cap) and style (growth or value). But a broad market index fund, such as the ( VTSMX) Vanguard Total Stock Market , which tracks the Wilshire 5000, can provide all of the above. Vanguard's Total Stock Market fund -- like other funds that track the Wilshire 5000 -- is heavily weighted toward large companies. That means total stock market funds do not provide asset class diversification. Because they have more of their assets in larger companies, their overall performance is largely due to the performance of large-cap stocks. You'll still catch a run-up in small companies, but it may not influence the fund as much as a drop in large-cap stocks will. While this is something to consider, also keep in mind that the market itself is weighted toward large companies and, ideally, your portfolio should look somewhat like the market. The S&P 500 makes up 85% of the total stock market's capitalization, which means those other 4,500 in the index make up less than 15%. That exposure to smaller companies will help smooth volatility, though. The S&P 500 peaked in March 2000, while the S&P SmallCap 600 peaked more than two years later in April 2002. An asset mix that held small-caps over the past two years would have mitigated the huge losses in large-caps. But since small-caps are generally more volatile, an equal weighting would be unwise. A total stock market fund and a total bond market fund, such as Vanguard's ( VBMFX) Total Bond Market , could be enough to get investors started.
Fund of FundsFunds of funds are typically expensive, since you not only pay an expense fee for the fund itself, but also the expenses on each of the underlying funds. The appeal, though, is that they allow smaller investors access to multiple funds that may have higher minimum investments. Some fund families, such as T. Rowe Price and Vanguard, waive the cost of the fund of funds (so their expense ratios are essentially zero), which means investors pay just the fees of the underlying funds. Since both houses offer low-fee funds as part of their funds of funds, they can be a more feasible option. Funds of funds can either be static or managed. The funds of funds in Vanguard's LifeStrategy series are designed to always hold a specific asset allocation, and the only rebalancing that takes place is to keep it in line with its stated goals. (The series has a fund for ( VASGX) Growth , ( VSMGX) Moderate Growth , ( VSCGX) Conservative Growth and ( VASIX) Income .) Other funds of funds, though, such as Scudder's Pathway Series, are more actively managed, with managers moving in and out of the underlying funds based on their assessment of the market and analysis of economic data -- much the same way a stockpicker manages a pure equity fund.
Lifecycle FundsLifecycle funds are a subset of funds of funds. Lifecycle funds, though, are not generally static investments. Rather, the mix of stocks and bonds changes as the investor ages. Most lifecycle funds have a target retirement date as part of their name. Two good examples of such funds are the just-introduced T. Rowe Price Retirement series (which range from ( TRRIX) Retirement Income for current or about-to-be retirees to ( TRRDX) Retirement 2040 , which has 90% of its assets in equities and zero in conservative fixed-income vehicles) and the Fidelity Freedom series, both of which change the asset mix as the retirement date gets closer.
"These funds make sure that investors don't get to retirement and find that their portfolio is still 100% invested in equities," Healy says. "Unfortunately, we've seen a lot of that over the past couple of years." We'd like to think, though, that readers of TheStreet.com are more sober and savvy investors than that. And if so, you're probably better off constructing your own portfolio with a small mix of funds chosen for their low expenses, tax efficiency and with the idea of maximizing return while minimizing volatility. You're all capable of that, aren't you?