Most informed investors will no doubt have built a portfolio that isn’t reliant on just one or two outcomes; however, though a selection of funds may look like they operate in different ways, investors could unwittingly be taking undue risk if they don’t do their homework.
We tackled this point in a recent study when we analysed how much diversification investors would have if they owned various global equity income funds. Though we focused on a number of worst case scenarios, we showed that investors can take massive regional bets without knowing.
The same can be said with sectors and individual stocks.
Managers will sometimes gravitate towards the same industries at points during the business cycle. At the same time, a certain sector may make up the large part of an index, meaning that some active funds will have a very high weighting to one part of the market.
One sector which is in vogue at the moment, due to the improving economy and the chance of higher interest rates, is financials. Banks and insurance companies also tend to be large constituents of developing market indices.
While the following are cherry-picked examples, they illustrated the possibility to high sector and stock-concentration in an apparently diversified portfolio.
Investors who want a globally diverse portfolio are likely to consider the likes of JOHCM UK Equity Income, Fidelity Special Situations, Invesco Perpetual European Opportunities and Lazard Global Equity Income for their developed world exposure and Aberdeen Asia Pacific Equity, Invesco Perpetual Latin America and Templeton Frontier Markets for their emerging market exposure.
Source: FE Analytics
Our data shows that an equally weighted portfolio of those seven funds has a 33 per cent exposure to financials.
The second largest sector weighting would be basic materials, which accounts for just 13 per cent.
The three companies with the greatest exposure in this portfolio are banks: HSBC, Lloyds and Itau Unibanco.
While banks and other financials may indeed be attractive sectors to be invested in, if things do go wrong, the risk of contagion is far higher than in other areas, as illustrated by the domino effect following Lehmans collapse in 2008.
Performance of indices between May 2008 and Dec 2008
Source: FE Analytics
Healthcare has been another favourite with fund managers in recent years – particularly those with an income-focus.
It is seen as one of the more defensive areas of the market, but due to its popularity, investors could well be doubling up their exposure.
Inevitably, many reading here will have exposure to CF Woodford Equity Income fund, run by renowned fan of pharma Neil Woodford.
An investor who has looked to diversify their exposure to large cap UK companies with an equal weighting to Neptune UK Mid Cap, Legg Mason Clearbridge US Aggressive Growth, Henderson European Selected Opportunities and Legg Mason Japan Equity, would have a portfolio with more than 30 per cent in healthcare.
Moreover, six of the portfolio’s top-10 individual stock positions would be either pharmaceutical or biotech stocks, including AstraZeneca and Novartis.
In nearly every IMA equity sector, managers have the ability to invest 20 per cent outside of their respective region.
This means that although an investor may be diversifying by region within their portfolio, they could have a number of stock-overlaps.
There have been a number of instances in the past when investors have been burnt by having too much exposure to just one company in their portfolios – BP being the prime example in 2010.
One of the most popular companies with both UK and global managers at the moment is GlaxoSmithKline, the FTSE 100 pharmaceutical giant.
Our data shows that more than 300 IMA funds count it as a top-10 holding and a number of those are taking punchy bets on the company.
While another extreme example, an investor who holds a seemingly diversified portfolio of highly-rated funds like CF Woodford Equity Income, Evenlode Income, Investec UK Special Situations, Newton Global Higher Income and First State Worldwide would have 6.36 per cent of their savings in GSK.
Apart from Newton Global Higher Income, each of those funds has at least 6 per cent in the company. Though it is commonly viewed as a relatively safe stock to invest in, no stock is safe from a major fall.
Indeed, GSK has had a turbulent few weeks after the management warned the market about its 2014 profits.
The stock has fallen by more than 10 per cent over recent months, and as the graph below shows, an equally weighted portfolio of those five funds has been directly impacted by those losses.
Performance of stock vs composite portfolio since June 2014
Source: FE Analytics
An interesting result from our research is that although managers have different styles, they can still take big bets on the same stock.
An example of this is Alastair Mundy’s Investec UK Special Situations fund and FE Alpha Manager Martin Walker’s Invesco Perpetual UK Aggressive fund.
They seem to complement each other well, as Mundy takes a very contrarian view on the market and is renowned for keeping a keen eye on the downside, while Walker looks to strongly outperform during rising markets.
However, if investors were to pair the funds together, they would hold 7.68 per cent in one company: Royal Dutch Shell.
As most investors will hold part of their savings in cash in the case of an emergency, it is likely they will want the money they set aside to be invested to actually be invested.
However, as concerns have been raised about the immediate outlook for equities and bonds, several high profile managers have raised their cash exposure to protect against the downside.
Our data shows that investors who hold a diversified portfolio could now have a lot of their money just sitting on the sidelines.
We created a portfolio using Unicorn UK Income, Trojan Income and Investec UK Special Situations for UK exposure, Veritas Global Equity Income, First State Asia Pacific Leaders, Somerset Emerging Markets Dividend Growth and Invesco Perpetual European Opportunities for regional exposure and Newton Real Return, Schroder MM Diversity Tactical and SJP Property as alternatives.
Again, it is a crude example, but even though it is relatively diverse, an investor in that portfolio would have 16 per cent of their savings in cash.
Funds’ cash weightings
Source: FE Analytics
Chris Spear (pictured), managing director at Spear Financial, says that investors shouldn’t be concerned if a high proportion of their invested savings is held in cash.
“I’ve been saying to clients recently that you either have to take risk or no risk at the moment. Your money has to be on the table or completely off it, there isn’t really any middle ground,” Spear said.“I think even if investors are taking a long-term view, I don’t think they should be worried if their managers are holding a lot of cash now. We pay them to make these decisions and it isn’t in their interest to be in the third or fourth quartile, they are just trying to protect their investors.”
The argument against this, of course, is that active managers are paid to invest.
Therefore, if a manager has a very high weighting to cash, shouldn’t investors just hold un-invested cash themselves and not pay the charges?
“That is a very fair comment,” Spear said. “But, human nature suggests that we will miss the boat. These managers should be able to jump on opportunities far more quickly than average investors.”
