Do You Need to Diversify by Fund Company?

I'm often asked whether it's OK to have all or most of your money with one fund company. My answer is that it depends on the fund company.

The most important reason is that mutual fund assets are held by custodians not affiliated with the fund company. Thus, a fund company in financial trouble couldn't simply start tapping mutual fund assets to make ends meet. The custodian holds a fund's securities and processes transactions. I've never heard of a fund company employee stealing from a 1940-Act fund, though of course there are other things a fund company employee could do to harm shareholders. It was telling that, when the Amerindo founders were accused of tapping client funds about 10 years ago, the mutual fund shareholders were not harmed.

What if the fund company goes bankrupt? It's a possibility. But we went through the financial meltdown of a lifetime in 2008-09, and no fund companies went bankrupt. The reason is that asset management is a capital-light business that generates steady fee income year in and year out. Nearly every fund company actually stayed profitable throughout the downturn. One fund company did see its parent firm go bankrupt: Neuberger Berman was owned by Lehman Brothers at the time Lehman went belly-up, but Neuberger was insulated from that. It was subsequently bought out by the firm's principals, and investors in its funds were unharmed.

The custodian relationship ensures that a struggling company wouldn't be able to steal shareholder money even if it wanted to. That said, I wouldn't put all my money in the actively managed funds of a firm that runs all its money in-house. There are some real risks in a situation where all your money is being managed by one group of people. Think of Janus in 1999: The firm was heavily tilted toward the growth names that got hammered in the 2000-02 bear market, so quite a few of its funds got walloped.

Simply having proper diversification into value and bonds would have lessened your risks, but you'd have to have gone outside Janus for much of that exposure.

So, boutique firms are generally not places you should invest your whole nest egg. Besides having similar biases, you'd also be at risk from an exodus of talent. This wouldn't likely be an overnight disaster to your portfolio, but it could lead to a prolonged slump if you didn't move your money. Industry cliche says that all of a firm's value rides an elevator out the door each day: It's in the people running money--and they can leave anytime they want.

Giant firms like Fidelity or T. Rowe Price can offer tremendous style diversification, but you still shouldn't have all your money with them, because of the small chance that a bunch of managers and analysts could leave at the same time. However, if you put a sizable chunk of your assets at Fidelity's index funds, investing your whole nest egg there would be fine.

Vanguard is the firm at which I would feel most comfortable investing all my money. It has passive funds for just about any need, so I wouldn't have to worry about everyone making the same bet or leaving at the same time. In addition, it spreads actively managed money around quite a few subadvisors, so there's not much exposure to any one. And if there were a brain drain at one of the subadvisors, Vanguard could easily fire that firm and move the money to a more stable company.

So, by all means diversify by asset class, style, and sources of active management. But you can invest quite a lot with a good firm without losing any sleep.

Another Perspective The always thoughtful Taylor Larimore expanded on the subject in the Bogleheads website here.