When constructing a portfolio, diversification is an obvious priority for many. You want to make sure you have good exposure across the board (in terms of assets, sectors and geographies) and that you haven’t got too many eggs in one basket, to put it plainly.
A lot of the time we focus on the former in investment commentary – the best funds to include in a portfolio, the countries on the up, the sectors set to flourish in the next cycle. All well and good. But we rarely cover the risk of overdoing it and diluting investment returns.
We often ask fund managers about their convictions when we meet them. A metric to look at is their number of holdings and how many assets are allocated to the largest, or top 10, of these.
This tells us a lot about how much conviction a fund manager and their team have in a given theme, but the other side of this is knowing how much discipline they have when it comes to conviction.
Simply put, if you over-diversify, you end up nullifying the investments you hold.
This can potentially do as much damage as having too much concentration in a singular stock or idea. Not only does this mean the upside you get from certain areas is minimised, by virtue of the number of holdings you have in general, but this also expands your exposure to other risks.
For the MGTS Qualis funds, the key distinction is between diversifying holdings and diversifying risks. Five funds owning substantially the same mega-cap technology companies may look diversified on a fund list but can amount to an expensive version of the index. Every allocation should bring a distinct return driver or solve a specific portfolio problem.
Diluting a portfolio can cause other headaches. The more holdings you have, the more time-consuming these will be to monitor. Even the most ‘set-it-and-forget-it’ long-term manager will find themselves stretched with an overabundance of holdings; with all the notifications and updates these bring.
This can also easily lead to over fiddling with a portfolio as so much information comes in, with each investment having their own risks to attend to.
It’s not cheap either. Diversification can be a worthwhile way of minimising a portfolio’s overall risk exposure, however the more holdings that you allocate to, the more these cost.
And we see a lot of this in the market – too many managers can easily risk diluting their best ideas, increasing fees and leaving the portfolio unintentionally benchmark-like.
This isn’t easy and some investors fall into the trap of diversifying their portfolios for the sake of it. They’ll subconsciously look to the direct opposite of what they’re already invested in.
Worried about overexposure to European large-caps? A dose of emerging market small-caps will balance that out. However, this can lead to obvious issues.
Our philosophy is essentially ‘concentrated thinking, diversified risk’: have conviction, but don't allow a single geography, style, sector or theme to determine the portfolio outcome.
A recent example of this occurred in our Qualis Growth Fund. We took the decision to reduce some Nasdaq concentration but retained our US exposure. We broadened into enhanced index exposure but, importantly, smaller companies and quality dividends was not a decision to become bearish on America. It was about creating more ways of being right.
Andrew Alexander is CIO and a fund manager at GWA Asset Management. The views expressed above should not be taken as investment advice.