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The Right Kind of Portfolio Diversification

The more active funds there are in a portfolio, the greater the chances of underperformance.

Articles by Betterment Editors

By the Editorial Staff
Betterment Resource Center  |  Published: June 21, 2013

Actively managed portfolios with two or more funds in the same asset class did dramatically worse compared to similar index-fund portfolios, according to research.

All index-fund portfolios containing 10 assets classes outperformed an active portfolio with comparable investments nine out of 10 times.

New research from Betterment shows that active funds don’t just underperform compared to index funds on average – they can be actively bad for the health of a portfolio.

A key finding from a new white paper released last week from Betterment and Richard A. Ferri, CFA, of Portfolio Solutions®, an independent investment firm, showed that actively managed portfolios with two or more funds in the same asset class did dramatically worse compared to similar index-fund portfolios.

For example, investors with a standard three asset class portfolio who hold three active funds in each asset class have less than a one in 10 chance of outperforming an index fund portfolio of the same asset classes.

The research also showed that all index-fund portfolios containing 10 assets classes outperformed an active portfolio with comparable investments nine out of 10 times.

Betterment’s Alex Benke, a member of the investment committee and a Certified Financial Planner™, said the findings underscored the importance of using an all-index fund portfolio for investors who want to maximize long-term wealth.

To conduct the research, the Betterment data team looked at returns from existing index funds and mutual funds, including mutual funds that have been shuttered, in order to most closely recreate the experience an investor faces. The research did not include portfolios managed by Betterment or Portfolio Solutions.

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