We get a lot of questions about the best funds to build a well diversified portfolio. There are many factors that go into it, but here is an article we published that describes one way to identify some good candidates. This article builds around the Fidelty funds, but the same approach can be used to select ETFs to get many of the same benefits.

Almost any article in the popular press about building an investment portfolio is quick to advise that you need to build a diversified portfolio. You then get some rule of thumb about buying stocks and bonds, or you need to buy 8 stocks from different industries, or you need 5% in precious metals or international stocks.

Here we will analyze the best mutual funds for diversifying your portfolio, and we will put try to quantify the impact, so you can see for yourself the improvement to not just the total return but the reduction in portfolio risk that you can get by properly diversifying.

The key to making diversification work is to find alternatives to the investments that you already have that not only have superior returns, but are not correlated to your current holdings, that is their day to day changes in value do not track another of your existing holdings.

For this example, we will use the Fidelity mutual funds family, simply because there are over 100 Fidelity equity funds alone, including the Fidelity Select Funds. This gives us a large universe of diverse options that should allow us to find the best Fidelity funds for our portfolio, with the convenience of keeping it all in one account.

We will start with a basic diversified portfolio of 70% Fidelity FSMKX, which tracks the S&P 500. Add to that a 30% holding of bonds, Fidelity Bond Index (FBIDX). This portfolio, if rebalanced quarterly from 1995 to 2005 inclusive, would have returned 11% annualized. The maximum drawdown (that is the most its value dropped from a previous peak) would have been a fairly steep 30% or almost 3 times the annual return. That of course was after the over 2 year bear market from March 2000 to October 2002 (when the S&P 500 had a 50% drawdown, which was better than the Nasdaq 100 almost 80%).

We then calculated the correlation of the Fidelity Equity Funds to that portfolio, while screening out some of the more volatile Select Family. The best Fidelity funds that showed a very low correlation to our portfolio were the Fidelity Real Estate fund and Fidelity Health Care fund. Both of these Fidelity funds have a long history (over 15 years) of providing reasonable good returns with reasonable drawdowns.

We reconstructed our diversified portfolio by adding 15% of each of these funds, so we now have and redistributing the rest, so the allocation now is:

50% S&P 500 index (FSMKX)
20% Fidelity bond index (FBIDX)
15% Fidelity Real Estate (FRESX)
15% Fidelity Select Health Care (FSPHX)

The portfolio was again rebalanced quarterly, for the same 11 years 1995 to 2005 inclusive. There resulting return was 12.5% per year, 1.5% better than the beginning portfolio. In addition, the drawdown was reduced to 24%, compared to 30% before. The drawdown is now only 2 times the annual return, a significant improvement.

As you can see, the real power of diversification is brought into play when we understand that low correlation between our investment holdings is key to making diversification work. Choosing a mutual fund family like Fidelity Investments that has a broad choice of sector mutual funds is a key part of choosing the best mutual funds for our investment portfolio.