Sector and listed regional diversification is becoming increasingly irrelevant, according to industry professionals, and investors should avoid the faux pas that concentrated portfolios aren’t sufficiently diversified. 
Diversification is often cited as the best possible way to risk-proof portfolios and, especially at this time of the year as the tax-free ISA deadline looms closer, investors are seemingly bombarded with material to support this.
However, diversification can be measured in numerous and vastly different ways. Not only this, there is also a risk that investors either buy overly-diversified funds or over-diversify their own portfolios.
In an FE Trustnet article published last year, Lazard’s Martin Flood (pictured) warned that there is a trade-off between diversification and returns and, according to studies, fund managers often fail to leverage their own stock-picking skills when constructing diversified portfolios.
“We feel that the goal of diversification is often taken to extremes and, at times, some managers have exchanged traditional risk control for returns,” he reasoned.
“We believe that many investors would be better served by using more concentrated portfolios, which allow portfolio managers to invest only in their best ideas and focus on stock picking.”
Also a manager of a concentrated portfolio, Kennox’s Charles Heenan believes excessive diversification in terms of number of holdings, sector weighting and listed regional weighting is a poor surrogate for real knowledge of holdings.
However, he believes investors should make sure underlying profit drivers are uncorrelated and truly diversified in order for a portfolio to be successful.
Since the launch of his 29-stock Kennox Strategic Value fund in 2008, it has outperformed its average peer by 36.34 percentage points with a total return of 138.2 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
“The key to building a portfolio is to choose good companies, don’t overpay and diversify. Try and build a portfolio that will hold up in different scenarios because absolutely no-one knows what is coming next,” the manager explained.
“If you can build something that will do well enough when markets go up and will hold up when things get tough, that’s very effective.
“How do we exercise ‘real’ diversification? Underlying profit drivers. It’s not about where they’re listed or what sector they’re in. It’s actually looking at where they derive their revenues and where their costs are going to come from. 
“If you have properly diversified companies, you have a much better chance of being resilient against unknowns.”
Will McIntosh-Whyte (pictured), assistant fund manager on the Rathbone Multi-Asset Portfolio funds, agrees that investors shouldn’t place too much emphasis on diversifying in terms of an asset’s listed region.
However, he believes investors should have exposure across industries to reduce the potential for unexpected disruptions, such as new technology or regulation, to hurt a portfolio.
“Regional diversification, including taking exposure to different currencies, is also necessary to reduce risk,” he explained.
“However, we drill down into our assets to find the geographic source of their earnings, rather than simply looking at where they are listed - something that is becoming increasingly irrelevant.”
McIntosh-Whyte says excessive diversification is often a criticism levelled at those who invest in funds, as opposed to multi-asset managers.
Broadly speaking, he says a major issue with over-diversification is the excessive level of trading costs that come with it. He also says it erodes active management, as investors can end up with a portfolio that tracks an index but has active fees.
“By deep-diving into the assets we hold, we avoid making unintended bets on industries, regions or currencies. And for the calls that we do make, we use complementary assets to hedge ourselves if markets move against us,” the assistant manager explained.
“For us, optimal diversification is a search rather than a strict formula: it’s the mix of assets that allows us to hit our return and volatility targets, but that mix is ever-changing. We are constantly testing our assumptions and thinking about how tomorrow might be different.”
While the multi-asset team at Rathbones tends to invest in bonds and equities directly, it will use funds for areas such as high yield bonds and Asian equities.
When it comes to selecting these, it typically prefers managers that are high-conviction and aren’t afraid to make punchy calls.
“It does also depend on the asset class – for example, in a high yield bond portfolio we may err on the side of caution and use a more diversified fund to gain exposure to the asset class given its asymmetric risk profile,” McIntosh-Whyte added.
When building client portfolios, Mike Deverell – partner and investment manager at Equilibrium Asset Management – prefers to focus on how active a fund is as opposed to how concentrated it is.
He then combines these with passive funds so that, rather than holding active funds that closely resemble an index, portfolios combine index funds with truly active investment vehicles.
While this process mostly leads to holding highly-concentrated funds, it also means that broadly diversified funds aren’t off the table either.
While he holds the likes of Lindsell Train UK Equity, which consists of 30 holdings, he also holds Marlborough Special Situations, which has close to 200 holdings but behaves very differently from its benchmark.
Performance of funds over 5yrs
Source: FE Analytics
“There is no right or wrong answer on this,” Deverell explained. “What is important is knowing what the fund’s approach is before investing. If the fund then deviates from that approach then it is a cause for a concern and would cause us to challenge the fund manager.
“For individual investors, a good way of checking how active a fund is compared to an index is looking at tracking error. They can also look at the top holdings of the fund and compare that to the index.”