"Why have you got exposure to gold even though you think it will lose you money in the short-term?"
"Diversification."
"Why do you hold fixed interest in your portfolio even though you just said yields couldn’t go down any further?"
"Diversification."
"Why do you hold 80 stocks in your UK equity portfolio even though you refer to yourself as a high-conviction investor?"
Yep, you guessed it, diversification was the answer.
Now, before our trigger-happy readers lambast me for suggesting investors shouldn’t diversify their risk and should just plough all of their hard-earned cash into a single asset class instead, I’d like to say for the record that this is in no way my intention.
What I’m keen to highlight are some of the myths surrounding diversification and whether – in some instances – there is such a thing as over diversification, which causes more harm than good to an investment portfolio.
Do more holdings mean less risk?
The general assumption is that a high-conviction portfolio with only a handful of holdings tends to be more volatile and risky than one with assets that have been spread far and wide.
This, on a basic level, makes sense: if you hold 10 companies in your portfolio and one does badly or even goes bust, it’s going to make a far bigger impact on returns than if the same company went bust in a portfolio of 100.
However, as Oriel Securities’ Patrick Barton (pictured) points out, this argument has its shortcomings.
"People seem to think a smaller number of holdings means funds are more risky, but to me it seems a lot more risky to invest in companies that I don’t fully understand." "It’s a lot better to be invested in companies that you know well and are confident with. I’m not interested in relying on an analyst to cover companies for me – I want to understand them myself."
Barton holds just 25 companies in his four crown-rated WDB Oriel UK fund. While he himself rejects volatility as a measure of risk, he says the fact that his fund has been less volatile than its FTSE All Share benchmark since he took over in 2009 vindicates his view to some extent.
Other high-profile, high-conviction managers include Nick Train, who holds just 24 stocks in his five crown-rated CF Lindsell Train UK Equity portfolio. The top-10 holdings – including a 9.6 per cent stake in Diageo and a 9 per cent stake in Unilever – account for 70 per cent of the fund’s assets overall.
According to FE data, the £652m portfolio is one of the least volatile funds in the IMA UK All Companies sector in recent times; FE data shows it has an annualised volatility of 14.73 per cent over a five-year period, compared with 17.6 per cent from the IMA UK All Companies sector average and 16.73 per cent from the FTSE All Share.
Train’s fund has also been one of the best performers over the five years on a total return basis.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Tim Cockerill, head of research at Rowan Dartington, agrees that a higher number of holdings does not necessarily mean less risk; however, he does think managers such as Train are something of an exception.
"I do think you can over-diversify, be it with funds or stocks," he explained.
"By definition, if you hold more and more holdings, it means that you capture more of the market movement, which means you become more and more like a tracker."
"There’s an argument that you can get all the diversification you need with 25 stocks, though I do think this needs to be taken with a pinch of salt, as it depends on what sectors the companies are part of."
"If you’ve got 25 companies that all sit in the mining sector, then you are increasing your risk quite considerably."
"I’ve seen a lot of managers with 25 holdings do very well and then suddenly fall by the wayside – you’ve got to do it for a very long time to prove yourself."
Tracker funds are particularly diversified, in that they hold every stock in a certain index. However, as an article by FE Trustnet’s Thomas McMahon recently demonstrated, these vehicles can expose investors to a huge amount of risk, as indices tend to be dominated by a select few sectors.
The FTSE 100, for example, is dominated by miners and banks, which have had a very tough time during the last decade or so.
Cockerill thinks holding a number of different stocks suits riskier mandates, such as smaller companies and high yield bonds, where the chances of default are much higher.
Performance of fund vs sector over 5yrs
Source: FE Analytics
He points to FE Alpha Manager Giles Hargreave (pictured), who holds around 150 stocks in his Marlborough Special Situations fund, as a good example. He has consistently beaten the IMA UK Smaller Companies sector average – which is also his fund's benchmark – over the last five years, with less volatility.
Multi-manager funds – do they work?
Multi-manager funds and all of the vehicles associated with them – be it funds of funds, managers of managers and so on – are the quintessential one-stop shop for diversification.
These vehicles give investors an extra layer of diversification than their more mainstream single-manager rivals, as the numerous funds they hold are themselves made up of stocks and shares.
However, while investors may expect this extra layer to ensure such funds are better protected from shocks in the market, FE Trustnet research suggests otherwise.
Our data shows that across all of the IMA multi-asset sectors, the average fund of funds has not only underperformed the average single-manager portfolio over various time periods, but it has also been more volatile, with a higher max drawdown. This measures what an investor would have lost if they bought and sold at the worst possible moments.
For example, in the IMA Flexible Investment sector, the average fund of funds has returned 33.94 per cent over a three-year period, underperforming the average stocks and shares fund in the sector by around 5 percentage points.
Performance of portfolios over 3yrs
Source: FE Analytics
Over the same period, the average fund of funds has a higher annualised volatility [10.7 per cent compared with 10.28 per cent] and also a higher max drawdown [14.75 per cent compared with 13.32 per cent].
Cockerill believes that funds of funds often end up being more volatile because managers are too focused on outperforming over the short-term – something that Hargreaves Lansdown’s Mark Dampier recently flagged up in an interview with FE Trustnet.
"The logic of funds of funds makes a lot of sense – we run this kind of model on a client-by-client basis," said Cockerill.
"The problem is that in such a competitive environment, when there are some major players, managers are forced to take on more risk in order to stand out from the crowd and get into that top quartile."
"As a result, managers are effectively putting more of their eggs into one basket by making big asset allocation bets. This is probably the reason for the increase in volatility."
If this is indeed the case, it begs the question whether investors with adequate expertise and time should build a portfolio themselves.
What does this mean for private investors?
The above details the issues of diversification for professional fund managers running individual mandates, but what about private investors who have their own future riding on performance?
For private investors, Cockerill says, diversification really is all it is cracked up to be.
"The fact of the matter is, even the very best experts aren’t very good at knowing what’s going to happen over the next week, month year and so on. Economic forecasters are notoriously very bad," he explained.
"As a result, diversification is very important. Who would have thought Japan was going to be the best-performing region in 2013? I certainly didn’t."
Cockerill says it is fine for investors to make asset allocation calls around the edges, but that the real priority should be the quality of manager.
"If you don’t like commodities, I wouldn’t say you have to hold them because the equity managers you hold can get exposure to mining stocks. In this case, you should probably leave that call to them," he said.
"If you’re not keen on bonds, it’s a bit more difficult, because it depends on what your objectives are. If you rely on income, then naturally you’re going to be drawn to certain asset classes."
"If your bond fund is yielding 4 per cent and that yield rises to 5 per cent the next year, you’ve lost a bit on the capital side but at least you’re still getting your income. However, if you’re a young person with a long time horizon, I don’t see a lot of point in holding bonds, to be honest."
Cockerill says a portfolio of between 10 and 20 funds more than suffices for a private investor, with a greater number of funds dedicated to the asset classes that have a bigger weighting.
He thinks it is important to select funds that perform in different ways to ensure they do not all fall at the same time, but says that the quality of the manager you are invested in is the most important factor.
"Say you hold 15 funds, a typical investor is probably likely to hold five UK equity funds," he said.
"A couple of equity income funds that behave in different ways, such as Invesco Perpetual Income and JOHCM UK Equity Income; a smaller companies fund; a more growth-focused fund; and then something that does things a little bit differently, such as Alastair Mundy’s Investec UK Special Situations, which tends to do better when the market is struggling."
He says he is a big fan of holding "insurance policies" within a portfolio – even if it conflicts with your overall view of the world. Cockerill explained this in a recent interview with FE Trustnet, with regard to funds run by Troy and Ruffer that are currently positioned to protect against a worst-case scenario.
