While I understand the value that these massive growth stories create for posting numbers at the end of the term, I can’t help that feel as though this is inherently wrong, given that investors aren’t really buying mutual funds to gain exposure to a few improperly hedged bets. If we wanted that kind of exposure, we could simply buy the security itself. Over the course of this article, I’m going to describe how it is that we can use this tendency for managers to over-expose themselves to their favourite positions to earn some good returns, and avoid management expenses.
When we evaluate a mutual fund as an investment, it is usually very easy to find information about the top-ten positions of the security online. It is from this information that we will be able to determine whether this fund is truly diversified, or just a diluted out equity position. Firstly, we need to look at how many securities are held in total within the fund. From there, we look at what percentage of the fund is composed of the top-ten holdings.
For example, if we have a fund that has 100 holdings, with 65% of the fund’s assets being invested in the top-ten holdings, we can suddenly see how it is that the remaining positions will likely be completely insignificant. Since each remaining would need to be less than a percentage point of the fund’s holdings to make up that difference, meaning that any movement in those securities would have very little impact on the fund itself, if any at all. From this point we need to ask ourselves if exposure to only 10 securities is really worth the ~2% management fee we’d need to pay for ownership. Personally, I prefer to avoid that expense if possible, and here’s how I do it.
In the event that a fund is presenting favourable returns, volatility, and suitability for my personal portfolio, but it is only really exposed to its top-ten positions, I’ll take advantage of the holdings report as a free-tip from a professional advisor. Since the top-ten holdings are really what it creating the majority of the returns for this fund, I’ll simply buy these securities in proportion within my own portfolio.
While this does require me to pay a bit more upfront for brokerage commissions, and exposes me to a slightly higher amount of volatility relating to my exposure to the securities themselves, the returns will no longer be diluted out by unnecessary positions in other companies. The long-term result will then likely be that my portfolio will be able to match or exceed the performance of the fund, while saving me the yearly cost of the fund expenses.