Beware To Be Aware Of Replication

Most people who take advantage of a company sponsored tax-favored retirement or health savings plans often commit a cardinal sin of investing. They fail to research the investment options before allocating their contribution and the company’s match. It is not enough to research the mutual funds. You also need to look at the underlying securities. Much to my chagrin, many options within 401k and HSA plans often overlap the underlying securities, albeit at different percentages. What do I mean by that? Let me give you an example.

Not too long ago, an acquaintance asked me to help him analyze his investments across three accounts. He had the standard brokerage account, a traditional IRA, and a Roth IRA. After reviewing his current position, all of which were chosen by a “professional” financial planner, I discovered this sin of replication.

The following example includes actual numbers. I use this example to highlight the repetition in just one of the accounts. Based on the common top ten holding, if the industry takes a hit, so too does each of the four CEFs (Closed End Funds). The result is a magnifying effect of losses. Of course one could argue that if the industry does well, the gains will also be magnified in the positive direction. However, one needs to know the industry before committing this type of strategy.

This person’s financial advisor had him invested in 4 CEF's in his brokerage account. The top 10 holdings in these 4 CEF's duplicate each other as seen in the tables below. (Price is of 4/18/2018)

Notice the repetition of companies; over $90,000 invested in essentially the same companies although at varying percentages. This is not diversification. It is replication and is actually a risky strategy.

For those who participate in any company sponsored 401k or HSA plans, understanding the underlying securities that make up the mutual funds in which a person may invest is important. For example, in the HSA account offered by Health Savings Administrators, there are five Vanguard funds that replicate their top ten holdings. This is astounding. The following table illustrates my point.

If, for some well-intentioned reason, a plan participant distributed his or her contribution across these five mutual funds, he or she is at risk of magnifying any potential loss based on the number of times a security is replicated. If the If Facebook, Apple, Alphabet, and Microsoft took a hit, all five mutual funds would take a hit and the loss would be magnified.

My suggestion is before you invest in any mutual fund, regardless of the type of account, do some analysis on the underlying securities. True diversification means not replicating the underlying securities, especially not the top ten holdings. If you have questions about how to analyze mutual funds, leave a comment.