Thu. Jul 18th, 2024

A reader sent me an email posing an interesting question — how much diversification is too much? 

Peter Beavis is in his 60s and happily retired. “Next week, I have my annual review meeting with my independent financial adviser [IFA],” he says. “You know the one. This is where he tells me to ‘Keep patient’, ‘take the long-term view’ but ‘most importantly, in this market, you need to diversify’. 

“Despite the onset of occasional grumpy old man syndrome, I think I’m reasonably patient and, hopefully, I can afford to take a long-term view of life as I’m in pretty good health. So I have passed my IFA’s first two tests, but it is the third one that is causing me concern.”

His financial adviser has spread his “modest-sized” self-invested personal pension (Sipp) investments across 30 different funds but Peter questions if it’s necessary to diversify to this extent. 

“Am I into the realms of ‘over-diversification’, where too many holdings lower the expected return to a point where my attitude to risk becomes irrelevant?”

It’s a good question which I recommend Peter puts directly to his IFA. A true professional would welcome such a robust challenge and respond with a concise and clear response. If they can’t, reconsider using their services.

The standard answer is that a high level of diversification ensures that if one fund performs badly, it doesn’t cause your whole portfolio to fall in value.

Human error can creep in to harm performance, with the most painful recent example being the Woodford scandal of 2019 that has left some investors still waiting to get their money back. But funds can also underperform their peers or (worse) their benchmarks simply by making the wrong calls, fund managers can fall ill or go through mental strain that affects performance. If one of those things happens to one of your holdings, high levels of diversification can mean it doesn’t devastate your retirement pot.

If you had held a Woodford Equity Income as part of a 30-fund portfolio, you probably wouldn’t be having such sleepless nights as the thousands of investors who lost their life savings by overconcentration in the “star” manager’s flagship fund.

But is it necessary to hold so many? The DIY investment platforms recommend between five and 15 funds as more than enough.

AJ Bell uses between five and nine funds for its ready-made fund portfolios and suggests this is sufficient to allocate money to different types of funds and markets without doubling up too much. It’s also a manageable number to monitor and won’t cost you too much in trading fees.

Interactive Investor uses between 10 and 12 collective investments (including funds, investment trusts and ETFs) for each of its five model portfolios.

Meanwhile, Fidelity recommends that for an experienced investor with a £100,000-plus portfolio, anywhere between 10 and 15 funds is more than enough. It says: “Advisers will typically recommend that your minimum fund size is at least 5 per cent of your portfolio, so that’s £5,000 invested in a single fund in the case of a £100,000 portfolio. It can also be prudent to limit exposure to any single fund to no more than 15 per cent of your overall portfolio.”

I think Peter is right to worry that holding 30 funds “means the percentage holdings in some funds in my portfolio is as low as 1.6 per cent”. That means each individual fund isn’t pulling much weight in the portfolio.

To get a better picture, I’d drill down into portfolio holdings using Morningstar’s X-ray tool at This is available via the premium service at £19 a month but your first 14 days are free. If you cancel during this trial period, you will not be billed.

The X-ray looks into funds’ underlying holdings and identifies any stock overlap — it shows which funds are holding the overweight stocks too. It reveals if your portfolio is over- or underweight in each geographic region or sector, and reviews how assets are diversified across stocks, bonds and cash.

Peter could then compare his portfolio to a highly diversified tracker fund, such as one in the Vanguard LifeStrategy range. If they aren’t so different, Peter should ask himself whether this portfolio’s diversification is at risk of turning into its evil twin, “diworsification” — resulting in a portfolio that performs like a tracker fund, but has higher charges eating into performance.

If you invest in actively managed funds that aim to beat average stock market performance, you can expect to pay ongoing fees and charges of around 0.9 per cent for each year of your total investment in the fund, according to research by AJ Bell. So that’s £900 every year on a portfolio worth £100,000. 

The cynic in me still worries that unnecessarily high diversification and complex portfolios can be used to justify the additional fees levied by IFAs

That’s a premium of around 0.75 per cent in extra charges vs the average tracker fund. It might sound a small difference, but watch out for the effects of compounding. If £100,000 is invested for 20 years and grows on average by 6 per cent a year, that 0.9 per cent charge would eat up £50,000 of investment returns in charges, according to a charges calculator at Candid Money. A tracker fund charging 0.15 per cent, on the same fund and investment growth, would take just under £9,000 in charges.

It’s fine to pay extra if you’re sure of better performance. But Peter says his fund has grown by precisely “zero” this year and he doesn’t know if this is good or bad. He should ask his IFA to give some comparison with a benchmark stock market index, or a 0.15 per cent tracker fund that he could reasonably be holding instead.

As prep for his review, Peter could use the website, powered by ARC Research, to check his fund’s performance against how other wealth managers are performing. He may be reassured.

But the cynic in me still worries that unnecessarily high diversification and complex portfolios can be used to justify the additional fees levied by IFAs. It’s easy for a client to see that monitoring 30 funds on a quarterly basis would take hours of time to do properly, even just to check the managers and strategy haven’t changed. Then there’s rebalancing to do: if the asset allocation moves, you’ll have to buy or sell holdings.

You might not want to take this on by yourself. But you wouldn’t have to if you bought a tracker fund or two.

Moira O’Neill is a freelance money and investment writer. X: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill.

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