One of the more frequently asked questions I get is about the need to diversify across mutual fund or exchange-traded fund providers: Is there risk in having all your eggs in one fund family's basket? This question became even more prevalent after the Bernie Madoff fraud was exposed.
We'll begin to address this issue by first discussing how to think about diversification of financial assets. If you use diversified, actively managed funds, you still have idiosyncratic manager risk. So, you should at the very least consider diversifying that risk.
With passively managed funds, such as index funds, that risk isn't present. It doesn't matter which fund family's S&P 500 index fund you own, because except for the expense ratio, the returns of all S&P 500 index funds should be virtually identical.
The same is true for index funds in other asset classes. With index funds, diversification is about the assets in the funds, not who is managing them. That holds for other passively managed funds or "structured funds," such as the three fund families my firm Buckingham uses, AQR, Bridgeway and Dimensional Fund Advisors (DFA). Their structured portfolios are all rules-based: No real human judgment is being employed regarding market timing or individual stock selection, except with the small amount of block trading they might engage in.
Thus, the bottom line is that with passively managed funds, diversification is all about diversification of the assets, not diversification of the managers.
Returning to the issue of manager or fund family risk, it's important to understand that Madoff was able to execute his massive fraud because, like the Wizard of Oz, he operated behind a curtain. On the other hand, publicly traded mutual funds operate with a high degree of transparency. Among the advantages of investing in publicly traded investment vehicles are:
1. Publicly held mutual funds are a highly regulated industry, by the Securities & Exchange Commission. Hedge funds, like Madoff's, are totally unregulated.
2. Mutual funds are required to have audited financial statements. In the case of DFA, PricewaterhouseCoopers, a major accounting firm, performs annual audits. These audits verify the mutual funds' financial statements, including correspondence with the custodians, brokers and transfer agent that confirms the securities held.
3. Mutual funds don't act as custodian of the assets. In the case of Buckingham's clients, their funds are held in custody at Fidelity, Schwab or TD Ameritrade.
4. Mutual funds don't perform the fund's accounting themselves. In the case of DFA, PNC Bank performs the fund's accounting.
In addition to these benefits, here are further important considerations. A manager of a Vanguard index fund or a DFA fund (or any other passively managed fund) has no incentive to take risks to try outperforming (the failure of such efforts often leads down the path to perdition as fund managers seek to recoup losses).
And these funds don't attract assets the way hedge funds do by weaving stories about how they can beat the market or earn market rates of return while taking less risk. The goal of all index funds is simply to earn market rates of return. Unlike hedge funds, they offer no incentive fees that would tempt managers to take risks.
Lastly, the historical evidence demonstrates that the returns earned by DFA's funds are consistent with their stated strategy, without any episodes of either dramatic over- or underperformance beyond what would be randomly expected.
The bottom line is that with all the protections available to investors in publicly held mutual funds, as long as you avoid actively managed funds, you don't need to diversify across fund families. When you should consider diversifying across fund families is if one family doesn't provide a fund in an asset class or strategy (such as the carry trade) you want exposure to, or if the fund family doesn't offer the best alternative in every case.