How to Diversify with Big Funds

If you're shopping in a mutual fund supermarket, it's pretty easy to achieve diversification. After all, there are thousands of funds to choose from. However, it's a different story in a 401(k), where you might have only a handful of options. Your choices may be limited to just a few big funds, and that can be a problem, because funds tend to look more like the broad market the bigger they get.

Ideally, you would want to diversify based on Morningstar style box classification and fund company. Again, your options in these areas may be limited, so you might want to take a look at a fund's R-squared figure. R-squared is a measure of how closely a fund's returns move in sync with an index's. (For domestic stock funds, we use the S&P 500.) A number above 90 indicates that it's pretty close to the index. The lower the number, the greater the diversification. The R-squared figure, however, does not tell you how good or bad the investment is, just how different. (For more on R-squared and other statistics, see Morningstar's data definitions.)

I ran a screen of domestic stock funds with more than $10 billion in assets to find five big funds with low R-squared figures. I've shown them here from lowest to highest. You can run a similar screen using the  Premium Fund Selector.

 Fidelity Growth Company  (FDGRX)
The fund has an R-squared of just 39, which is quite low for a large-cap fund. Manager Steve Wymer differentiates it from the S&P 500 by making it growthier and smaller. The fund owns faster-growing companies and even has twice the index's weighting in tech stocks. Wymer also invests about a third of the portfolio in small- and mid-cap stocks so that the fund's returns aren't driven by mega-caps like the S&P 500 is. The fund's growth bias means it has taken a pounding of late, but Wymer has beaten two thirds of his peers over the trailing five years, and it's a pretty good bet the fund will reward investors the next time growth stocks rally.

 Vanguard Windsor II  (VWNFX)
You could bookend the S&P 500 with this fund and Fidelity Growth Company. James Barrow likes stocks that are significantly cheaper than the overall market, and that has given the fund an R-squared of just 41. He's got a contrarian streak that leads him to buy stocks that are surrounded by controversy, such as Tyco . A while back he made a big bet on utilities stocks when everyone hated old economy stocks, but it paid off nicely.

 T. Rowe Price Equity-Income  (PRFDX)
This fund is also cheaper than the S&P, but whereas Windsor II is bold, T. Rowe Price Equity-Income is cautious. The fund stands out from the S&P 500 by being less volatile. (Its R-squared clocks in at 46.) Manager Brian Rogers keeps individual stock weightings low so that no single company can torpedo the fund. Throw in the added protection of dividends and the lack of price risk, and you've got a very tame fund.

 American Funds Washington Mutual  (AWSHX)
This offering is one of the best stock funds for protecting against absolute losses. It's down 11% this year, but that would mark only its third calendar year loss in 25 years. This fund places a greater emphasis on dividends than T. Rowe Equity-Income does, but less emphasis on issue risk. In fact, its top positions can individually occupy as much as 4% to 5% of the fund's net assets. It adds in a different kind of diversification, however. Assets are divvied up among a number of managers who run their portions independently. Thus, you get style and manager diversification, too. This fund's R-squared is 48.

 Fidelity Low-Priced Stock  (FLPSX)
It shouldn't be a surprise that this fund made the list because it's the only small-cap fund with more than $10 billion in assets. It's in thousands of 401(k) plans including Morningstar's, and that's a good thing. Its small-value orientation should keep it from being like the S&P 500 (it has an R-squared of 49), and its broad diversification will make for a smooth ride. Amazingly, manager Joel Tillinghast has produced outstanding returns even though this fund dwarfs the rest of the small-value competition.