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8 Steps for a 2015 Portfolio Cleanup: Morningstar’s Benz

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Some people have too many sweaters stuffed in their closets, and lots also have extra mutual funds, ETFs or stock holdings cluttering their portfolios, according to Christine Benz, director of personal finance for Morningstar.

Many investors have a “glut of ‘stuff’ in their portfolios, she says in a recent piece on the research firm’s website.

“For every single portfolio I receive that’s whippet-thin — without an excess stock, fund, or ETF to spare — I come across 10 more that have 50, 60 or even 100 individual holdings,” Benz wrote.

Though having too many holdings isn’t as bad as saving too little or chasing performance, “portfolio sprawl,” as she calls it, can give investors challenges they don’t really need.

“It can simply be difficult to keep track of the fundamentals of so many holdings, especially if those holdings include individual stocks or actively managed mutual funds. The investor with too many holdings may have trouble figuring out their asset allocations or knowing when or how to rebalance,” the finance expert said.

“Having too many stocks and funds can also compound the headaches for an investor’s successors. Widows, widowers and other loved ones may have difficulty untangling the web of the too-acquisitive investor,” she noted.

Furthermore, portfolio sprawl also can negatively affect performance.

“If an investor amasses a lot of holdings, especially multiple diversified equity and bond funds, their performance within each asset class can become very index-like very quickly,” according to Benz. “But if that same investor is paying active management fees, sales charges or some combination thereof, the portfolio may well underperform a buy-and-hold portfolio consisting of simple index funds with ultra-low costs.”

Thus, she advises investors to streamline their portfolios by following these eight do’s and don’ts:

Merge Similar Accounts

1. Merge Similar Accounts 

As people change jobs, they pick up multiple 401(k)s and IRAs.

“Rolling all of these orphan accounts into a single IRA can be a great way to clean up the mess in a hurry, giving you just one major account to monitor on an ongoing basis,” according to Benz.

“Not only will you be able to populate your IRA with nearly anything you like, but you’ll also be able to cut out the administrative costs and above-average fund fees that come along with some 401(k) plans, especially those of smaller employers,” she wrote.

The process can begin with the decision to have one fund company or brokerage house the IRA.

Ideally, the providers should roll the funds directly so the investor doesn’t need to receive any checks in the mail.

Watch Out

2. Watch Out 

Combining 401(k)s and IRAs into a single IRA may not be the right move for every situation, Benz advises.

“In particular, assets in 401(k)s and other defined-contribution plans enjoy blanket protection from creditors. Meanwhile, the creditor protection of IRA assets will depend on the laws in your state,” she pointed out.

Plus, some 401(k)s and other defined contribution plans may offer investment types that an individual investor cannot get access to, such as stable-value funds or ultra-low-cost institutional share classes.

Take the Best; Leave the Rest

3. Take the Best; Leave the Rest

While many investors manage each separate 401(k), IRA and other account as a well-diversified portfolio unto itself, it’s preferable “to reduce the number of holdings in your portfolio and ensure that each is best of breed by thinking of all of your retirement accounts as a unified whole,” Benz says.

“That’s because it’s the total portfolio’s asset allocation that matters, not the allocations of the constituent portfolios,” she explained.

If a 401(k) plan has excellent equity-index funds, for instance, but weak bond options, then an investor might want to keep lots of equities in the 401(k) and more bonds in the IRA.

Use Caution

4. Use Caution

Diversification in accounts is especially valuable for investors approaching retirement age.

“Because you want to retain the flexibility to pull assets from any of your accounts during retirement — Roth, traditional or taxable — you may have good reason to hold both more- and less-liquid asset types within each of your accounts,” Benz noted.

This can provide more flexibility when it comes time for withdrawals.

In a high-tax year, it’s best to make a tax-free withdrawal from a Roth IRA, for example, rather than taking money from a 401(k).

Given that investors will turn to their Roth accounts at some point, it also is worthwhile for that account not to be 100%-focused on equities — “hold some safer securities, such as bonds and cash [in them], too,” she adds.

Watch the Ratings 

5. Watch the Ratings

When it comes to cutting down on holdings that play the same role in a portfolio, an easy way to make head-to-head comparisons is by using Morningstar’s Analyst Ratings.

These are the star rating for stocks and the medalist system for funds.

“These ratings are designed to provide a forward-looking assessment of a security’s prospects,” Benz stated. “Of course, you may have good reason to hang on to securities that don’t rate well — for example, you may have a very low cost basis” on some holdings.

Still, the ratings make for a good starting point.

Don't Obsess Over Trailing Returns

6. Don’t Obsess Over Trailing Returns 

Especially when comparing two portfolio holdings that play a similar role, don’t focus too much on their trailing returns, advises Benz.

“Despite recent volatility, the market has rewarded risk-taking, since it began to recover in early 2009. By focusing disproportionately on investments with happy-looking trailing returns — especially over the past three- and five-year periods — investors may inadvertently tilt their portfolios toward higher-risk, higher-volatility investments,” she stressed.

To avoid such a trap, look at the risk profile of each investment.

Look at their returns in 2008, and at Morningstar’s upside/downside capture ratios for funds, Benz suggest.

“And if you’re looking for a data point with the greatest predictive power for mutual fund performance, a fund’s expense ratio is the best way to stack the deck in your favor. You can’t go too far wrong by concentrating your holdings in the lowest-cost investments in your choice set,” she said.

Use Broad Funds

7. Use Broad Funds  

The upside of broad-market index funds and ETFs is that they include some exposure to small and large companies, as well as some that are value- and growth-oriented.

Total U.S. bond market index funds “won’t be quite as encompassing,” points out Benz; for example, they are not likely to include Treasury inflation-protected securities (TIPS) or junk bonds.

Still, they should give investors in the accumulation stage representative exposure to the U.S. investment-grade bond market and thus can be useful.

“Even if you also hold actively managed funds, by anchoring your portfolio in index funds, you’ll be able to get away with fewer holdings and bring your portfolio’s average costs down,” the finance specialist said.

Stocks Need Lots of TLC

8. Stocks Need Lots of TLC

Though many investors use mutual funds or ETFs to make up the bulk of their holdings, some also own a small basket of stocks.

If you generate strong results from your stock holdings, it might be worth expanding this part of a portfolio.

But if you are a more haphazard equity investor with little time or inclination to watch individual stocks, it may be “a good time to ask yourself what those small positions are actually doing for you,” says Benz. “If your total position is fairly small, it’s adding to the clutter in your portfolio but doesn’t have the potential to dramatically alter your bottom line, for better or for worse.”

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