4 Investment Strategies for Managing a Portfolio of Mutual Funds

4 Investment Strategies for Managing a Portfolio of Mutual Funds
4 Investment Strategies for Managing a Portfolio of Mutual Funds

DMP / Getty Images

Reviewed by Cierra Murry

Most American households are invested in mutual funds because they provide relatively easy exposure to a diversified mix of stocks, bonds, and other assets. Many choose these financial products to avoid managing their portfolios, and many workers begin saving into one through their 401(k)s and other retirement accounts. But you still need to think strategically about which funds to choose and how to manage investments, often meant to be held for much of a lifetime.

This is even more true if you’re investing in several funds to diversify your portfolio further. Doing so used to be more popular before the advent of target-date funds, which meet many, but not all, of the reasons for wanting a portfolio with different funds. However, as mutual fund fees have come down and they have pushed into niches and investment strategies first seen with exchange-traded funds (ETFs), there are prudent reasons to seek multiple mutual funds for your portfolio.

Below, we discuss four ways you can make the most out of building a portfolio of mutual fund investments. Using these straightforward approaches, you can ensure your fund choices remain aligned with your financial goals without undoing the work of your main retirement mutual fund manager.

Key Takeaways

  • Mutual funds spread risk across securities and diversify their portfolios for more stable returns.
  • Investing in a portfolio of different mutual funds provides the advantage of professional management by experienced fund managers. This offers invaluable expertise for investors who may not have the time or knowledge to manage their investments.
  • Mutual funds are usually convenient and sufficiently liquid, making them easy to trade into or out of when necessary.
  • When selecting a portfolio of mutual funds, the main task is to ensure you continue to diversify your assets while looking for the value you can add to them in other funds.

What Are Mutual Funds?

Mutual funds are managed investments that pool money from many investors to buy a diverse portfolio of stocks, bonds, or other securities. The specific mix held by the fund depends on its goals, which could include growth, income, or a combo of both.

Before mutual funds, individual investors, especially those without substantial wealth or expertise, couldn’t achieve the diversification that mutual funds provide. Imagine trying to buy small portions of 500 different stocks on your own—it’s both time-consuming and expensive. Until the 1970s, not only did you have to buy this mix of securities yourself, but even the funds that did so were privately held. That changed in the mid-1970s when Vanguard began offering the public a mutual fund, now called the Vanguard 500 Index Fund (VFIAX), which tracked the S&P 500 index—essentially, the 500 top American companies.

However, their use began expanding greatly in the early 1980s after legal and regulatory changes made it easier for employees to save for retirement using 401(k) plans. These shifts allowed workers to reduce their taxable income by contributing to employer-sponsored retirement accounts. Mutual funds quickly emerged as the primary investment option within these plans thanks to their simplicity, built-in diversification, and professional management.

Buying a small stake in these funds meant you owned a slice of an extensive, diversified portfolio. This is important since it would seem moot to need further diversification beyond a single fund These funds also offer professional management. Most U.S. households are invested in them, with U.S. mutual funds holding almost $20 trillion in assets in 2024, compared with $12.6 trillion a decade before and $5.6 trillion a decade before that. Their fees have also come down over time, and they differ by the type of securities they hold. The upshot of these lower fees is that it’s more feasible to buy stakes in several funds without assorted fees eating up any profit potential.

By spreading investments across assorted assets, mutual funds minimize the risk of significant losses and often offer investors good returns. From 2002 to 2022, the average mutual fund averaged annual returns of 12.86% for investors.

Why Invest in Multiple Mutual Funds?

Mutual funds are very effective at diversifying your portfolio. By pooling capital from many investors, fund managers can invest in a broad range of selected securities, spreading risk across different assets, which can lead to more stable returns over time. There are several thousand funds, and if you don’t find the asset coverage or diversification with one, surely you’ll find it with another.

So why hold multiple funds? Diversifying your holdings is a basic principle of sound financial planning, but holding several mutual funds could mean over-diversifying to the point that you diminish your returns. Adding another or several mutual funds seems to add even more variety, but you might reduce your potential returns from an overlap in holdings. Alternatively, the assets in the fund might not be the same, but they might react similarly in the same economic conditions, increasing your risk.

Drawbacks When Investing in Multiple Funds

Managing one mutual fund and other assets in your portfolio is quite enough work for most, but doing so for several increases the complexity of what’s involved, especially if one of those funds is a target-date fund, with holdings and investment strategies that change over time to match your likely needs as you advance toward retirement age.

Example of Redundant Holdings

Let’s say you’re among the over 80% of American mutual fund investors who choose a target-date fund. For each paycheck, you put money into your 401(k) for the Fidelity Freedom Index 2050 Fund (FFNOX), a popular target-date fund. Say you’re happy with this choice but want to add other investments to this mix. However, this can lead to an overlap of assets and end up being counterproductive.

For example, you might like to invest in large-cap stocks like Nvidia Corporation (NVDA), which you keep hearing about. FFNOX is already very diverse, holding Treasurys, international bond funds, and emerging market stock funds. Still, you might think that adding a low-fee, well-performing, large-cap growth fund would boost your portfolio.

So, let’s look closer at what’s already inside FFNOX. The fund holds a significant portion (around 80%) of U.S. stocks, including a good portion of large-cap growth companies from its investment in Fidelity’s S&P 500 index fund—over 40% of its holdings in 2024.

Thus, adding a separate large-cap growth fund to your portfolio would be redundant. You’d essentially be doubling down on the same types of stocks, increasing your risk and lowering your diversification. You’d be increasing your stake in what’s already the majority of FFNOX’s fund while reducing the amount in your entire portfolio of Treasurys, emerging market stocks, and bonds also held by FFNOX, which are there to help mitigate your risk.

You’d also be undoing the rationale for investing in FFNOX in the first place. Target-date funds automatically rebalance their holdings over time to bring them in line with your expected needs as your retirement draws closer. Adding more mutual funds could interfere with this changing fund. To avoid this, you’ll need to consider changing your own portfolio of funds as FFNOX does.

Analyzing what’s already in your mutual fund investments is critical before adding more holdings. When people combine different funds within a portfolio, redundant or excessive concentration is a common problem.

Reasons To Invest in Multiple Funds

Despite these pitfalls, there are times when holding several mutual funds can be a reasonable strategy. If you’re looking for targeted exposure to certain sectors, geographies, or asset classes, you might search for many of the specialized or niche mutual funds in these areas. Below are the main types of mutual funds, with the percentage given for their mutual fund market share in 2024. We also note their relative risk and rewards, left to right.

<p>Investopedia</p>

Investopedia

Customization is a key reason most invest in multiple mutual funds. Rather than the “one and done” approach of target-date funds, you want something more tailored to your risk tolerance, goals, or even personal beliefs. Target-date funds tend to follow a one-size-fits-all approach—growth stocks early on and putting more fixed-income securities into the mix as you age—so you might want a more personalized approach.

You could handpick funds based on specific sectors, asset classes, or market capitalizations, adjusting your exposure according to market conditions or personal preferences. You might also seek higher returns through actively managed mutual funds, believing the typically higher fees they have over index and target-date funds are worth it.

Investing in multiple mutual funds could allow you to manage risk more precisely by balancing high-risk and low-risk funds, those focused on different regions, specific sectors, or securities. While mutual funds were designed to do away with the need to go out on your own, even well-designed target-date funds can underperform. As such, you might think investing in multiple funds can hedge against the risk should this happen with your mutual fund. You might see the target-date fund as taking care of your core retirement savings, but you want more exposure to specific niches. Let’s look at examples and derive some lessons from them.

Example of Strategically Holding Multiple Mutual Funds

Suppose that when you began planning your retirement, you had time on your side with about three decades before you turned 65. While onboarding at your company, you pick a health insurance plan and so on, then select the Vanguard Target Retirement 2055 Fund (VFFVX) for your 401(k), a diverse target-date fund tailored to shift from growth to income as the years 2051-2055 approach. But you always had ideas for how you wanted to invest when you started paying into mutual funds, so you decide to add some sectors that aren’t covered by VFFVX. You want to invest in these areas, but you want to remain on the path to retirement.

Thus, you keep 85% of your portfolio in VFFVX. But you allocate 5% each to four funds:

  1. Fidelity Infrastructure Fund (FNSTX): You have always been interested in how infrastructure is a sector that does fine even when the market goes down. You also know it’s often a hedge against inflation, a problem that target-date funds don’t typically help much with. FNSTX invests across the world in transportation, utilities, communications, and other forms of infrastructure, and its past performance and managerial experience make it a match for you.
  2. Harbor Small Cap Growth Fund (HASGX): You also choose a fund that puts you in line for more growth prospects than your target-date fund is likely to provide. Given your time until retirement, you think you can take on even more risk, and small-caps are certainly more risky than the large-caps that make up much of VFFVX’s equity portfolio. With 72 holdings, HASGX is wagering on relatively few companies in pharmaceuticals, information technology, and heavy industry to make outsized gains.
  3. Fidelity Climate Action Fund (FCAEX): You also want some of your portfolio to be in companies addressing climate change and its impact. FCAEX, which holds about 80% of its stocks in companies that fit this bill, has a higher expense ratio than the others at 1.05%. However, you’ve diligently reviewed its holdings. Yes, it does double up on VFFVX’s S&P 500 holdings when those companies meet FCAEX’s criteria. But you’re doing so mindfully, considering the overlap in this smaller part of your portfolio as worth it.

Let’s now discuss four strategies you would use when adding these funds to your portfolio.

Investment Strategy #1: Diversification, Not Over-Diversification

Anyone picking additional mutual funds for their portfolio is diversified already. The task is to avoid over-diversification, which is when you spread yourself so thin you’re unlikely to profit should any particular assets have significant appreciation. The trick is to continue in the direction of giving further variety to your portfolio from different sectors and assets without diluting your ability to reap the rewards if they should come. This means choosing three sectors that don’t just double up on what’s likely to be in your target-date fund. The three you’ve picked in FCAEX, HASGX, and FNSTX fit the bill.

Doing this strategy well requires meticulous oversight of your primary mutual fund’s holdings as they change in the coming years. You don’t want to double up on certain sectors unwittingly. If you do want more in a specific area, such as choosing a fund, FCAEX, that might invest in S&P 500 large-caps (as mitigating climate change), you need to do so mindfully, knowing the risks of doing so and considering how to balance those out in other parts of your portfolio.

Investment Strategy # 2: Be Strategic With Your Time Horizon

You’re keen to add some high-octane small-caps, but only because if this proves to be a less-than-ideal investment, you have time to make up for it. So, you keep your allocation to HASGX large enough to make a difference but not so big that it could threaten your retirement.

This strategy is all about aligning your investments with your time horizon. When you have more years to invest, you can afford to take on more risk in pursuit of higher potential returns. Small-cap stocks, like those in the HASGX fund, are known for their growth potential but also have more volatility. The crucial part is finding a balance, not only in the size of your investment in small-caps but also over time. By investing in small-caps while you have a longer time horizon, you’re giving yourself the chance to benefit from their growth potential with years left to make up for potential problems ahead.

Investment Strategy # 3: Focus on Value-Added Investments

You didn’t just pick any mutual funds to add. You chose those that offer prospects that are different from each other and the holdings of your primary mutual fund. With infrastructure, you noted their potential for protection from inflation and their returns not being correlated with the broader market. The small-cap mutual fund you chose has a higher risk-reward ratio, given your relatively long time frame. Lastly, you aligned your ethical values with your motives to gain returns by investing in a theme, such as climate change mitigation, that is forecast to see growth in the years ahead.

As such, you sought out funds that bring something genuinely new and beneficial to your portfolio, not another helping of the same.

Investment Strategy # 4: Active Monitoring While Ready To Rebalance

You wouldn’t have started looking beyond your target-date fund if you wanted a set-it-and-forget-it approach. Once you did, you couldn’t start buying stakes in niche funds and put them out of your mind until the next blue moon comes around. You now have several moving parts to manage. Higher-risk investments like small-cap funds might outperform your target-date fund by a wide margin (or underperform just as much).

This could throw off your desired portfolio allocation, especially as you age and your target-date fund also changes its holdings. Rebalancing means reviewing your portfolio—having a financial advisor on hand to help is wise—and adjusting your holdings to ensure they remain in line with your risk tolerance and goals.

Undoubtedly, a regular and careful portfolio review is essential in mutual fund management as it ensures the investment aligns with the investor’s financial goals, risk tolerance, and market conditions. Over time, shifts in the market can act against your original intentions, exposing your portfolio to unintended risks or causing you to miss growth opportunities. You started off well, taking care when choosing a portfolio of mutual funds. Disciplined investing will help see you through when changes are needed.

Regularly reviewing your mutual fund’s performance allows you to identify any deviations from your initial target asset allocation. This process might reveal the need for rebalancing to ensure your overall portfolio of mutual funds continues to meet your risk tolerance and investment objectives. Adjustments should be made thoughtfully, considering both current market conditions and long-term financial goals.

How Often Should I Review and Rebalance My Mutual Fund Portfolio?

It’s typically recommended that you review and consider rebalancing your mutual fund portfolio annually or whenever there is a significant change in your finances or investment goals.

What Is Dollar-Cost Averaging and Can I Use It For Any Mutual Fund

Yes, dollar-cost averaging—making set periodic deposits into your fund regardless of market conditions—can be used for any mutual fund.

What Are Some Signs That My Asset Allocation Needs Adjustment?

Signs that you need to consider changing your portfolio include significant changes in your financial goals, your ability to handle certain levels of risk, or a major difference between what you expect from your portfolio and its results.

Are Mutual Funds Always Actively Managed?

No, mutual funds can be either actively managed or passively managed by tracking a specific index. However, the majority of funds still have an active fund manager. But, over the long term, this could be changing. The Investment Company Institute has reported that from 2013 through 2022, index domestic equity mutual funds and ETFs received $2.5 trillion in net new cash and reinvested dividends, while actively managed domestic equity mutual funds experienced net outflows of $2.3 trillion, showing almost a zero-sum game where index funds see inflows whenever there are outflows from actively managed funds.

The Bottom Line

Newer investors are typically warned off investing in other mutual funds once they begin using target-date or life cycle funds. This is because experienced managers are better able to manage your need for diversification and rebalancing as the market and your time to retirement draws nearer. Adding more funds to the mix risks undoing their work.

That said, when carefully done, adding a mix of mutual funds can add diversification and niche investments to which you would otherwise not have access. In this article, we went over four strategies to use, namely carefully checking your main fund’s holdings and seeking diversification from there, being strategic about your time horizon, focusing on those places where you can add value (not simply add more of what you already have), and making sure to monitor your portfolio of funds and rebalance when necessary.

Read the original article on Investopedia.

admin