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Why Overdiversification Matters to the ERISA Fiduciary

November 01
00:10 2011

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Confucius said “To go beyond is as wrong as to fall short.” This defines the latent lesson of overdiversification.

According to the DOL (see “ERISA Fiduciary Advisor: What are fiduciary responsibilities?”), fiduciary responsibilities include, among other things, “diversifying plan investments.” The DOL doesn’t explain “diversifying,” but it does 753315_73191025_ominous_sun_stock_xchng_royalty_free_300suggest “plan assets should be diversified to minimize the risk of large investment losses,” but that “fiduciaries should consider each plan investment as part of the plan’s entire portfolio.”

Furthermore, the DOL states, (From DOL: “ERISA Fiduciary Advisor: What are my liabilities as a fiduciary and how can I limit them?”), 401k plan sponsors, in order to give participants control over the investments, must:

  • Allow the participants “to choose from a broad range of investment alternatives.”
  • Provide “at least three different investment options so that employees can diversify investments within an investment category, such as through a mutual fund, and diversify among the investment alternatives offered.”
  • Disclose “sufficient information” so participants can “make informed decisions about the options offered under the plan.”
  • Permit participants “to give investment instructions at least once a quarter, and perhaps more often if the investment option is extremely volatile.”

The DOL goes on to say “if an employer appoints an investment manager that is a bank, insurance company, or registered investment advisor, the employer is responsible for the selection of the manager, but is not liable for the individual investment decisions of that manager,” assuming that investment manager is not a non-discretionary adviser. However, even if the adviser performs a discretionary role, the DOL says “an employer is required to monitor the manager periodically to assure that it is handling the plan’s investments prudently.”

Still, like ominous storm clouds obscuring a weary sun, the DOL warns (from the DOL’s “Meeting Your Fiduciary Responsibilities”), “while a fiduciary may have relief from liability for the specific investment allocations made by participants or automatic investments, the fiduciary retains the responsibility for selecting and monitoring the investment alternatives that are made available under the plan.”

For this reason, a 401k plan sponsor cannot merely delegate investment decisions to a third party. Plan sponsors must continually update their education on matters pertaining to investments in order to assess the prudence of bother the vendor’s recommendations as well as the prudence of selecting that particular vendor.

The complexities of Overdiversification – and how it harms 401k investors – represent just one area of investments 401k plan sponsors must education themselves about.

In his book, You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits, Joel Greenblatt, founder of hedge fund Gotham Capital, says investors can cut the nonmarket risk – the part of a stock’s risk that not tied to movements of the broad market – of owning one stock by adding one to the portfolio. In addition, he suggests risk can be cut by 81% by owning only eight stocks. Interestingly, once the portfolio contains eight issues, Greenblatt says “the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.”

Greenblatt might be famous but he’s a bit off when it comes to the number of stocks an optimally diverse

In his article “How Much Diversity is Enough?” (Investors Alliance Investor News, April 1995), author Bill Staton references page 126 of Richard A. Brealey’s book, An Introduction to Risk and Return from Common Stocks. Of Brealey, Staton says “he shows the amount of risk in portfolios ranging from two stocks to 2,000. Brealey says that a simple five-stock portfolio provides 77.4% of the benefits of diversification if each is in a different industry. Eight companies brings that number to 85.7% while 12 gets to 90.4%. Thus, as even dozen companies produces more than 90% of the benefits of diversification. Fifty companies gives an investor 97.7% protection while 100 brings 98.83%. Adding 400 more companies provides another 0.93% protection. That’s roughly 0.002325% per additional stock.”

Staton concludes “owning more than 10-12 solid companies is too much for most people because (1) it’s not necessary to obtain excellent diversity, (2) each additional stock reduces the chance of having a winning portfolio, and (3) there’s more to keep up with, especially if you’re in dividend reinvestment plans.” Staton implies it’s acceptable to accept 90% of the benefits of diversification. The consensus among academic researchers indicates a better objective is 30-40 stocks, where one achieves approximately 95% of the benefits of diversification.

As a practical matter, the DOL holds 401k plan sponsors responsible for prudently monitoring the investment advisers they choose. Advisers who recommend funds with hundreds of stocks raise the issue of increased fiduciary liability as academic research would demand a greater level of justification for placing these types of funds among a plan’s options. Plan sponsors might want to take heed when Staton quotes Louis Lowenstein, professor of finance at Columbia University, who says “holding a lot of stocks guarantees mediocre results because, ‘in effect the fund becomes a proxy for the market.’”

The DOL does not define prudence, other than to say it is a process rather than a result. The DOL adds the recommendation that 401k plan sponsors carefully document their due diligence process. In practice, then, 401k plan sponsors shouldn’t reject mutual funds with hundreds of holdings, but they should maintain written documentation why these funds were selected in light of the prevailing academic research.

Long ago, Confucius issued this portent: “Faced with what is right, to leave it undone shows a lack of courage.” This describes the lurking liability of overdiversification.

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 4th Deadly Sin – The Overdiversification
Part II: A Trip Down Memory Lane – Revisiting Portfolio Optimization
Part III: Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio
Part IV: Why Overdiversification Matters to the ERISA Fiduciary
Part V: How Plan Sponsors Can Help 401k Investors Avoid Overdiversification

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

1 Comment

  1. Lynne McAuley
    Lynne McAuley November 16, 23:57

    Thank you for this series of articles. I am going to pass them on to my colleagues.

    Lynne

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