Investors are often told that the key to an outperforming portfolio is diversification, as putting all your eggs in just one or two baskets can leave your savings overly dependent on a certain outcome. 
A traditional method of diversification is to use a core UK fund and spread risk by introducing other regional equity funds. However, one of the potential pitfalls of that strategy is that certain UK managers will go through periods of underperformance as their style falls out of favour, meaning investors could miss out on potential relative returns.
As such, many professional investors look to partner-up two UK funds with different styles, market-cap exposure and risk-profiles to give their clients a more well-rounded return during the market cycle.
One of whom is Ian Rees, head of research at Premier and co-manager of various multi-asset funds in the group, who has decided to blend two top-performing UK funds for his exposure – namely John Wood’s JOCHM UK Opportunities and Henry Dixon’s GLG Undervalued Assets.
Both funds are headed up by FE Alpha Managers, have outperformed over the longer term and have done so by generating high levels of alpha. However, those market-beating returns have tended to come at different stages of the cycle, as Rees explains.
“John Wood uses a quality filter on the stocks he is invested in,” Rees (pictured) said.
“He focuses on businesses which are cash generative and deliver a sustainable return on invested capital. It is a low-turnover approach with a quality angle, which means it has generally performed well from a risk-adjusted sense and from a drawdown point of view. Fortunately, Wood has also been able to capture market upside.”
“He is very much of the Warren Buffett school of thinking such as rule number one, don’t lose capital and so he buys companies that don’t waste it. Then there is rule number two, don’t forget rule number one.”
Wood launched his now £1.5bn JOHCM UK Opportunities fund in November 2005 and his portfolio has historically been biased towards the large-cap end of the FTSE All Share.
According to FE Analytics, the fund has been a top quartile performer in the highly-competitive IA UK All Companies sector since launch with returns of 131.30 per cent, beating its FTSE All Share benchmark by close to 45 percentage points in the process.
Performance of fund versus sector and index since launch
Source: FE Analytics
It has also been a top quartile performer for its alpha generation relative to its benchmark, and its information ratio over that time.
Given Wood’s focus on quality, it is no surprise to see that outperformance has largely come during periods of market stress.
FE data shows it was a top decile performer in 2007’s turbulent market and the crash year of 2008, made a positive return in 2011 when the European sovereign debt crisis left the FTSE in negative territory and was top quartile again in 2014 when macro-headwinds increased.
Its performance in flat and falling markets means JOHCM UK Opportunities has had a strong capital preservation profile over the longer term. Since launch, it sits in the top decile for its annualised volatility, risk adjusted-returns (as measured by its Sharpe ratio) and its maximum drawdown.
However, investors will have no doubt seen that Wood has struggled relative to his peers and the wider market during ‘risk-on’ phases of the cycle.
While his fund still delivered double-digit returns in each of these years, JOHCM UK Opportunities underperformed against the FTSE All Share and the sector average in rising markets like 2009, 2010, 2012 and 2013.
That, as Rees points out, is where Dixon’s GLG Undervalued Assets fund comes in.
“Because of Wood’s style, he does tend to lag in really strong rising markets. Also, because he focuses on quality, he has to relax his valuation criteria. That’s why blending the GLG fund has worked really well,” Rees said.
“It is a value fund and that can lead Dixon to some quite poor quality companies or to more cyclical businesses, which means the fund can perform well in rising markets but not so well in falling ones.”
Dixon has been managing value-orientated portfolios in the Investment Association universe since August 2008 and has built a strong investor following as a result of his performance on the FP Matterley Undervalued Assets fund (which was a top decile performer and comfortably beat its benchmark during his tenure).
He launched his new GLG Undervalued Assets fund in November 2013, which uses the same disciplined approach revolving around stocks that he considers to be undervalued relative to their asset base and to the returns on capital the companies are generating.
Performance of fund versus sector and index since launch
Source: FE Analytics
According to FE Analytics, the £365m fund has been a top decile performer since inception with gains of 22.5 per cent, meaning it has more than doubled the FTSE All Share’s return over that time.
The fund, which has much higher weighting to mid and small-caps than Wood’s portfolio, has not had to deal with a proper falling market but managed to deliver top quartile returns in 2014 and is also top quartile so far in 2015.
While the fund has been one of the sector’s best performers for risk-adjusted returns, alpha generation and information, its maximum drawdown has been larger than the index and its average peer.
It is a similar story when you look over Dixon’s career - while he has considerably outperformed his peer group composite, his value style and preference for smaller companies means he has done so with bigger drawdowns.
Rees uses a simple 50/50 split when blending the two portfolios, which has worked well since they have both been in existence.
According to FE Analytics, the composite portfolio has comfortably outperformed the sector and index since the GLG fund was launched and has done so with lower volatility, a higher Sharpe ratio and a smaller maximum drawdown.
Performance of composite portfolio versus sector and index since Nov 2013
Source: FE Analytics
Of course, that is a relatively short period of time. However, when you combine Dixon’s longer term numbers with the JOHCM it throws off a similar result.
FE data shows that the composite portfolio (JOHCM UK Opps and Henry Dixon 50/50 split) has massively outperformed against the FTSE All Share and sector since Dixon launched his FP Matterley fund in August 2008 with returns of 113.11 per cent.
Except for 2009 when the portfolio underperformed by 2 percentage points with gains of 28 per cent, the blend of Wood and Dixon’s strategies has beaten the sector and index in every calendar year during the period in question.
It has also generated a high level of alpha relative to the index, has a Sharpe ratio which is twice as high as the average fund in the sector and has had a far lower maximum drawdown.
Performance of composite portfolio versus sector and index since Aug 2008
Source: FE Analytics
“The blend has a lower volatility than [if it’s] owned on its own and this means an appropriate blend can improve the information ratio and reduce the beta which enhances the risk/ reward outcome,” Rees explained.
GLG Undervalued Assets and JOHCM UK Opps have no commonality in their top 10 holdings, with Dixon preferring out of favour cyclical stocks such as banks (HSBC and RBS feature in his top 10) as well as the basic material sector.
Wood, on the other hand, counts defensive mega-caps such as Unilever and British American Tobacco in his top 10. He also has a 19 per cent weighting to cash, reflecting his view on valuations in the current market and his wish to protect capital.
JOHCM UK Opps has a clean ongoing charges figure (OCF) of 0.81 per cent, but carries a performance fee of 15 per cent like all of JO Hambro funds. GLG Undervalued Assets’s OCF is higher at 0.98 per cent, but it doesn’t have a performance fee.
