There is a widespread belief that by holding more stocks, a manager can reduce the volatility in their fund by minimising the effect of any one company on the portfolio.
However, Seaton (pictured) says that there are better ways to reduce volatility and that investors in funds with a high number of stocks can end up with a riskier investment.
"We believe it is better to know a lot about a little rather than a little about a lot, the latter being typically how the index-based funds are run," he said. "We are very focused on a select number of companies within the UK focus fund. It has a hard cap on the number of investments it can make of 35 holdings."
"If you take the UK market and look at the FTSE 100, (which is about 84 per cent of the total UK market by market cap), banks, miners and oil and gas account for approximately 40 per cent of the index, which is very weighty."
"If you go back to 2007 and had put money into an index tracker or passive fund, you would have been buying into these areas of the market and what they have gone on to do is produce lower returns and give significantly higher volatility."
"We can sidestep that and add value, not just through what we hold but what we don’t hold as well."
Many funds may not be index trackers per se, but they do limit the amount of "risk" a manager can take relative to their benchmark.
This means that they try to limit their tracking error – the amount their returns vary from that of the index.
This is less risky in the sense that it limits how much money a manager can lose relative to their benchmark, but it also limits the upside, meaning if the index falls then so does the fund.
SVG UK Focus can hold a maximum of 35 positions, which is designed to ensure that each is significant when it comes to generating returns.
Along with a cap on the size the fund can get to, this also ensures that the portfolio can continue to be invested in small and mid cap stocks as it grows.
Even though the fund has kept roughly one third of its assets in the FTSE 100 and one third in each of the FTSE 250 and FTSE Small Cap indices, it has been significantly less volatile than the large cap index.
An examination of 90-day rolling average volatility figures shows that being "diversified" across the broad UK market would have had negative consequences for investors in recent years.
Whereas the highest figure for SVG UK Focus, despite all its mid and small cap exposure, was 33.4 per cent over the past five years and the lowest 12.1 per cent, the FTSE 100 reached 54.9 per cent over the same time, with a low of 17.2 per cent.
A comparison with the performance of certain sub-sectors suggests one possible reason for this: the metals sector hit a maximum of 139 per cent and a low of 50.8 per cent, for example.
Ninety-day rolling volatility
| High (%) |
Low (%) | |
|---|---|---|
| SVG UK Focus | 33.4 | 7.9 |
| FTSE 100 | 55.8 | 9.6 |
| FTSE Banks | 89.9 | 17.2 |
| FTSE Metals | 138.9 | 27.4 |
| FTSE Oil and Gas | 68.8 | 11.5 |
Source: Bloomberg
"The range for the fund is less," Seaton said. "If you are putting a pound into a passive fund, you are taking on lower returns and higher volatility."
"I would argue that holding 25 to 35 companies is well-diversified," he added. "In terms of sector balance, our fund has a broader exposure to different industry groups than the UK market, which has 40 per cent in banks and resources."
"We have a hard cap of 20 per cent of NAV exposed to any one industry group and even our largest industry group exposure is some way below that."
"We think it’s less risky than putting £1 in an index: would you rather have £1 in a company that has been thoroughly researched with a very clear investment thesis and mapped out path to value creation, or own £1 in BP or HSBC just because it’s a large per cent of the index?"
The same pattern of underperformance for certain sectors is shown by annualised returns.
"If you look at the Focus fund, since the end of 2007 to 14 August, it has produced annualised total returns of 9.7 per cent," Seaton said.
"By comparison the FTSE 100 has delivered just 4.3 per cent and the oil and gas sector 3.2 per cent. Banks have delivered negative annualised returns of 5.5 per cent and metals negative 26.7 per cent."
"The fund has delivered higher returns with lower volatility. Supposed lower-risk passive funds have actually delivered lower returns and higher volatility."
Seaton says that his fund has had nothing in banks, oil and gas companies or mining companies for the entire period, which has helped it in terms of returns and volatility.
It is noticeable that the fund has been less volatile than the FTSE 100 despite holding a large proportion in smaller and mid cap stocks, which are traditionally more risky.
FE Trustnet research recently showed that the smaller companies sector in particular has been less volatile than its large cap counterparts.
Among the reasons for this will be the greater exposure to risky sectors of the large cap index.
Being in the mid caps has helped a lot of funds to the top of the IMA UK All Companies performance tables, as FE Trustnet recently showed.
SVG UK Focus sits in the top quartile over three- and five-year periods. Seaton took over management in 2009.
Data from FE Analytics shows that the fund has made 66.41 per cent over the past three years, compared with returns of 43.88 per cent for the average fund in the sector and 41.9 per cent for the FTSE All Share.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
However, Seaton says that the fund’s returns have not come from being in the FTSE 250, and he is wary of valuations in that market at the moment. The fund has 45 per cent in the FTSE 100.
"Our performance has not come through our mid cap exposure, which is where a large number of IMA UK All Companies funds have derived their performance," he said.
"On a 30 per cent premium to the FTSE 100, we feel that’s [FTSE 250 valuations] very stretched. With a focus on domestic earnings, we feel the FTSE 250 is subject to significant potential downside earnings risk."
Some commentators have suggested that the strong market returns in the UK are unsustainable, being based on increasing P/E multiples rather than underlying earnings growth.
However, Seaton, like FE Alpha Manager Ian McVeigh, says this re-rating can continue.
"From the trough of the market in 2009 to the middle of 2012, de-gearing and earnings growth were the primary drivers of the market," he said.
"We have argued for some time that the re-rating would also become an important driver of returns going forward."
