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Am I Too Overweight In Mutual Funds?

As investors, one of our favorite words is diversification. We are taught to diversify our portfolios to avoid exposure to any one particular investment or sector of the market and achieve balance. One of the easiest ways to achieve diversification is through purchasing mutual funds, which I did at the beginning of my investing career. However, now that I have grown as an investor and now own 30 individual stocks, I wanted to take a look back at my current mutual funds to determine if too much of my portfolio is allocated to these diversified holdings. It is time to take a look at the five mutual funds I hold and determine if ACTION needs to be taken. The Mutual Funds Currently, I own five different mutual funds . In total, the mutual funds total $16,200, or 25.5% of my total portfolio. These five funds are located in two different accounts, which impacts the accessibility of the capital if I were to decide to make a move. Roth IRA Three of the funds are located in my Roth IRA. I opened these positions during the infancy stages of my dividend growth investing career. At the time, I wanted both dividend income and diversification, so focusing on dividend paying mutual funds sounded like a great idea. So I took the capital I had and divided it evenly among the three funds listed below. ACLAX – 119.803 Shares; MV $1,994; 3.0% of Portfolio – This fund is a four star, silver rated fund on Morningstar. Some of the top ten holdings include: RSG , EMR (One of our favorites), NTRS , OXY , IMO , and CAG . The major selling points on this fund were the diversification, historical performance, strong/consistent management team, and the fact that the fund has a mid-cap focus but still pays a strong dividend. The one major downfall of this fund is the expense ratio, which is slightly over 1%. However, I knew that a fund centered on finding mid-cap funds would cost more than others due to the extra research and time needed to manage the lesser-known stocks. OIEIX – 138.551 Shares; MV $1,916; 2.9% of Portfolio – Another fours star, silver rated fund. This fund does not mess around and is focuses on large cap, value stocks. Some of the largest holdings include: JPM , XOM , JNJ , MO , AAPL , PNC , PFE , and HD . My favorite aspect about this stock is that it pays a monthly dividend. While my check usually isn’t that large on a monthly basis, as evidenced in last month’s dividend income summary, it is nice to see your position grow on a monthly basis. Isn’t that right Realty Income shareholders? MEIAX – 55.556 Shares, MV $1,952; 3.0% of Portfolio – Also a four star, silver fund. This fund has some overlap with OIEIX as some of the top holdings include: JPM , JNJ , PM , PFE , LMT , USB , and MMM (one of my favorites). However, unlike OIEIX, this fund pays a quarterly dividend and has a lower annual fee than the other two above. Since these funds are held in a personal retirement account and are not affiliated with my employer sponsored retirement account, I have the ability to trade these funds without restrictions and liquidate my positions at any moment. Employer Sponsored Roth 401(k) Accounts Like most of us that are still working for an employer, we have a 401k plan that allows us to select from a small pool of mutual funds or the company’s stock. For my company, we are allowed to select from a wide variety of Vanguard mutual funds. Vanguard funds are nice because of the extremely low expense ratios. In this account, I own two different mutual funds. VWNAX – 149.224 shares; $9,726.42; 14.9% of Portfolio. This Vanguard fund is a large-cap value fund with an expense ratio of just .27%, significantly lower than the three funds disclosed above. Some of the top ten holdings include JPM , MDT , PFE , BAC , OTCQB:MFST , WFC , PM , and PNC . If you recall, I left my current employer in March and returned later in the year. This was the mutual fund that I contributed to in my first stint at my current employer and I am no longer contributing to this mutual fund. Therefore, the only changes in value/shares owned are related to changes in market price and the receipt of dividends. Another interesting nugget about this fund is that it pays a semi-annual dividend in June and December. So it doesn’t pay frequently, but when it does, the dividend income checks have a huge impact on my monthly dividend income figures. Want proof? Check out my dividend income summary from the last time I received a payout. VINIX ­- 224 shares; $9,726.42; .8% of portfolio very similar to the last mutual fund. However, two small differences. First VINIX focuses on mirroring the S&P 500 versus investing in dividend stocks so the yield is slightly lower. Second, VINIX pays a quarterly dividend versus a semi-annual dividend. When I re-joined my old company, I thought it might be a good idea to invest in a new mutual fund to diversify my holdings. Since this position will keep growing, I didn’t want to become too overweight in one mutual fund. So now I will share the wealth in Vanguard and continue to max my contributions in this fund so I can receive the full benefit of my employer’s 401k match, which can be a very powerful tool for dividend investors. Analysis As I compiled the section above, there were a few things that jumped out at me. Here are some of the thoughts that came to my mind. There is a lot of Overlap ­- This became evident when I started listing out some of the major holdings in each fund. Outside of ACLAX, which focuses on mid-cap dividend stocks, there is a lot of overlap in holdings in the other four mutual funds. Which makes sense considering that these funds are focused on generating a dividend from large cap stocks and there are only so many stocks to select from. However, if my goal is to achieve diversification among these holdings, do I really need four different funds investing the same pool of stocks? Wouldn’t one suffice? Why am I paying Such High Expense Fees – Is it terrible that my answer is “I don’t know why?” At the time of investment, it made sense to invest in mutual funds. But I wasn’t as much of an expense hawk as I am now so I was willing to overlook the high expense ratios to achieve my goal of diversification. In this day in age, with ETFs designed to achieve the same goal as mutual funds with minimal fees, why on earth am I voluntarily paying this annual fee? A stupid/reckless mistake on my part. I understand paying a fee for a mutual fund that invests in mid or small cap stocks because these companies require more time and research to identify/trade successfully. But paying a fee to invest in a pool of highly covered large cap stocks seems ridiculous going forward. Lack of REITs in Holdings – This one kind of surprised me, especially considering I selected these funds with a dividend-focused attitude. I did not see one REIT in any of the mutual funds I own. I am sure there is some reason why and the tax rules may be too unfavorable for fund families. This was just an interesting observation to me so I wanted to share it all with you. Where do I Go From Here? Based on my analysis and observations above, I think the answer to the title of this article is yes. Holding five mutual funds, which account for over 25% of my portfolio , seems a little heavy. Especially considering that many of the mutual funds invest in the same pool of stocks and are accomplishing the same goals. Well, first things first. Let’s talk about the liquidity of these funds. Since two of my mutual funds are in an employer-sponsored plan, there isn’t much I can do outside of investing my capital in a different mutual fund. And trust me, Lanny and I have performed plenty of research on the available plans in the portfolio and we have selected two of the best. So as of now, I am not going to touch the two Vanguard funds and I will continue to invest in VINIX with each paycheck. Our employer matches 50% of all contributions, so I will continue to contribute the maximum amount each paycheck that will allow me to receive the full employer match next year. Plus, the expense ratio is very low, which is a huge positive compared to the other funds. While I can’t liquidate my two Vanguard funds, it is a completely different story for the three mutual funds in my Roth IRA. I have the freedom to trade these funds as I please. When I initially invested in these funds, I was at a different stage of my investing career and I needed the diversification. However, now that I have grown as an investor, owning 30 individual stocks, there is no need to diversify through owning independent mutual funds. The fees are too high and diversification is achieved through my employer’s plan. So after I receive my capital gain distribution in December, which always results in a nice payout, I am most likely going to sell these funds and use the ~$6,000 to invest in some powerhouse dividend stocks. Which stocks will I invest in? I’m not entirely sure yet. I’m going to special screener in the next month unique to this situation that will help me identify how I should allocate the $6,000 in capital when it becomes available. The screener will look to identify great companies with a long-term track record with a yield in excess of the yield I am receiving on these dividend-focused mutual funds. I’m not certain yet, but I believe one of the moves I am going to make is to invest half in Realty Income based on the results of my last stock analysis. Another option is to focus on one of the stocks on my “Always Buy” list or one of the high yielding stocks on our foundation stock listing. What are your thoughts on my strategy? What percentage of your portfolio are allocated to mutual funds? Do you think I am overweight? Should I consider investing in ETFs in lieu of mutual funds or dividend stocks with the capital to maintain the diversification? Do you have any recommendations for stocks that I should consider?

Investing In A Better World… For A Higher Return?

Global investment and business community is increasingly incorporating ESG principles. Remarkably, investors are limited in their choice in passive and active instruments to play the sustainability-theme. This may have a reason, since returns are not (yet) competitive. In a world driven by cold hard yields, the consequences of the operations of companies is sometimes neglected. Investors could well forget the values they believe in when investing for a secure retirement. We often are quite firm in our discussions in how we view the world, politics and society, but do not always incorporate our believe in our portfolios. Yes, we search for trends and reflect on how different technologies could shape the world and therefore future profits, but do we also consider whether companies and products can shape a world in which we want to live? Sustainable investing is the investment approach that considers global social and environmental challenges while building a portfolio. To be fair, there’s an increasing amount of consideration for ESG-policies (Environmental, Social and Governance). Even Harvard Business Review’s list of the Best Performing CEOs considered ESG-criteria, often making or breaking a CEO’s ranking in the list. Yet, there’s still some reservations against sustainable and ESG investing among investors. There might be some prejudice against ESG and sustainability. Surely complying at ESG and sustainable criteria will cost companies money? Being more aware of waste, a more diverse working force and higher transparency (to name a view) would come at the cost of yield, some investors may think. But is this really true? Let’s find out! There are a number of ways to approach sustainability. According to US SIF (The Forum for Sustainable and Responsible Investment), “sustainable, responsible and impact investing is an investment discipline that considers ESG criteria to generate long-term competitive financial returns and positive societal impact. I put long-term competitive in italics here, since that is what we want to find out. Note that returns are put ahead of social impact. When looking at ESG-criteria, a number of company policies are identified. For example, focus on Environment means that the company has policies related to resource management and reduction of emissions i.e. reducing ‘footprint’. Social-criteria point to diversity, health, human rights, safety and community impact. Governance stands for shareholder rights, board accountability and disclosure, to name a few. The items mentioned above indicate that a company doesn’t need to be a second Greenpeace or Amnesty International to comply in order to be considered for a sustainable investment approach. For instance, Microsoft’s (NASDAQ: MSFT ) goal to go carbon neutral would make the shares of the company attractive for investment. Since a large number of S&P 500 companies are stepping up their commitment to ESG-criteria, the investment universe is quite large. Remarkably, there are not a lot of ETFs with a sustainable or ESG-based approach on the US market. Currently there are only two (relatively small) ETFs which have a multiple year track record: iShares MSCI USA ESG Select ETF (NYSEARCA: KLD ) and iShares MSCI KLD 400 Social ETF (NYSEARCA: DSI ). Early last year, ALPS launched its Workplace Equality ETF (NYSEARCA: EQLT ), which is very small however with only a little less than USD 10 million AUM (assets under management). Passive investors are therefore limited in their choice. However, the number of actively managed products is a bit larger, with US investors able to choose from 7 mutual funds. Unfortunately, not all of them have a track record of more than three years. In addition, the investment mandate may be global or restricted to a specific ESG-theme. Therefore, only 3 mutual funds are selected for a performance check, bringing the total to 5 instruments. Let’s first start with the ETFs. iShares MSCI USA ESG Select KLD seeks exposure to socially responsible U.S. companies and excludes tobacco companies. It tracks the MSCI USA ESG Select Index. The underlying index is designed by MSCI’s propriety ESG rating framework. Companies are reviewed by MSCI analysts on more than 500 data points and scores on 100 indicators. Companies get a rating that falls on a nine-point scale (AAA to CCC). The index is reviewed on a quarterly basis. KLD has an expense ratio of 0.5% and thus is more expensive than a regular US market ETF, such as the popular SPDR S&P 500 ETF (NYSEARCA: SPY ) (expense ratio of 0.09%). iShares MSCI KLD 400 Social DSI is based on the more restrictive MSCI KLD 400 Social Index. This index not only excludes tobacco, but also securities from companies involved in nuclear power, alcohol, gambling, weapons, GMOs (genetically modified organisms) and adult entertainment. In addition, companies should have a ESG-rating of above BB. DSI is therefore the ‘purest’ sustainability ETF on the US market. The performance of both ETFs are compared to SPY. A direct comparison to the S&P 500 as the broader market doesn’t make sense, since we’re looking for an evaluation of passive investments. (click to enlarge) The table leads to a clear conclusion: on the longer term, sustainability or ESG ETFs do not offer a competitive return. Although all three ETFs show a small positive return this year, over a 5-year period we see a significant underperformance. What is even more disturbing: a stricter interpretation i.e. better compliance to ESG values seems to lead to lower returns. But there’s a glimmer of hope: on a 3year basis, KLD beat the market. All three ETFs have a similar development over time, as the chart below shows. For neutral ETF-investors, there hardly seems an incentive to switch to more ESG-friendly instruments. (click to enlarge) Can active management provide a reason to move to sustainability? Let’s look at our mutual fund selection: Touchstone Sustainability and Impact Equity Fund (MUTF: TEQAX ) One of the older sustainability-themed mutual funds is managed by Touchstone Investments. The fund is active since December 1997 and therefore has a long track record. The asset manager is sub-advised by Rockefeller & Co. Inc. since May 2015. The investments are selected based on an evaluation of company’s ESG-practices. The investment process follows a bottom-up approach. DFA US Sustainability Core Portfolio (MUTF: DFSIX ) Dimensional Fund Advisors offers two mutual funds in the SRI-category: DFA US Sustainability Core Portfolio and DFA International Sustainability Core Portfolio (MUTF: DFSPX ). On top of that, it offers the DFA US Social Core Equity Portfolio which has a social oriented mandate. For comparison with the US market, DFSIX is included in our check. Northern Global Sustainability Index (MUTF: NSRIX ) The last product in our check is actually not an actively managed fund. NSRIX seeks to replicate the MSCI World ESG Index. Surprisingly, it has a lower expense ratio (net 0.31%) compared to the ETFs described earlier. Asset manager Northern Trust offers this mutual fund for the ‘socially conscious’ investor. The fund and its underlying MSCI index seek to track the performance of companies that comply to widely accepted sustainability principles. This instrument is included in the comparison to see how a global ESG-oriented allocation performs compared to the US market. Investors should be aware of the restrictions that come with investing in above mentioned instruments. The instruments are not available by all brokers and do have a minimum investment threshold which can run up to USD 2500. Also fees for redemptions may apply. As always, consult your financial advisor before making any investment. In our performance analysis, we ignore the indicated benchmarks of the mutual funds. Since we want to see if actively managed ESG-based strategies are competitive, the performance is compared to the broader market measured by the S&P500 Index. Neutral investors who look for an incentive may be less interested in specific benchmarks, but look for an outperformance on the broader market. This is of course arbitrary, but a comparison to different benchmarks would be of lesser use. Since the S&P 500 Index is a price based index, we should also look at the S&P 500 Total Return Index (SPTRX). All three mutual funds distribute dividends. (click to enlarge) The table above doesn’t give reason to become enthusiastic about sustainable and ESG investments. The underperformance compared to the broader market can’t be explained by higher costs, although a part can be contributed to (higher) expense ratios. When we look at the more recent yields and the return since the start of the bull market, actively managed instruments are performing slightly better that their passive counterparts. It should be highlighted that the DFA US Sustainability Core Portfolio is able to outperform the market on several timeframes. But this could be explained by good management and isn’t necessarily attributable to ESG-criteria, as its peers show. For now, the available instruments for sustainable and responsible investing do not show the competitive returns we hope to see. Neutral investors which are only interested in return are not offered an incentive to switch. Unfortunately, this leaves the investment category only interesting for a specific group of investors.