We are often asked about the investments that we select for your portfolios – and whether there is risk in having just a few managers across the range of asset classes.
Our view is that having the right managers beats having many. Here’s why.
Don’t we need to diversify across fund managers?
We believe that diversification is a key ingredient in investing successfully.
The important thing, however, is to first understand the risks to which your portfolio is exposed – and then to identify how best to diversify to minimise the impact of these risks.
There’s little point in adding more investments for the sake of diversification without understanding why you’re diversifying in the first place.
If you have a portfolio with actively managed funds, you still have idiosyncratic manager risk. This is because many active fund managers create relatively concentrated portfolios and rely on their forecasting skill to add value. These concentrated portfolios hold a limited number of securities, representing around 10 percent of a major market index like the S&P/ASX300 or the S&P500.
Investing with a single concentrated fund manager can also over-expose an investor to specific sectors or investment styles that the manager favours.
For investors with this type of portfolio, it certainly seems to make sense to spread the risk of a manager getting it wrong.
By adding a range of investment managers each with a small number of holdings, the investor can seek to diversify away the risk that one manager does poorly.
Seems logical, doesn’t it? However, there is a problem with this approach.
The problem is this: each investment manager has a separate mandate for their investment decisions. There is no overarching strategy, and no communication to coordinate investment decisions on the overall portfolio. This can result in several issues in the overall portfolio, including:
- Significant concentrations of individual securities.
- Active investment decisions working against one other – that is, one manager is buying a particular stock, while another is selling the same stock. In the end, the investor ends up with zero benefit and additional transaction costs.
Contrast this with a portfolio which includes highly diversified index funds and ‘structured’ funds, which are designed to work together to capture the market. In these funds, the issues we’ve discussed above don’t apply.
With index funds, it doesn’t matter which fund manager’s S&P/ASX200 index fund you own, because except for the expense ratio, the returns of all S&P/ASX200 index funds should be virtually the same. The same is true for index funds in other asset classes. With index funds, diversification is about the assets in the funds, not who is managing them.
This also holds for structured funds – which have portfolios which are rules-based: no human “calls” are being made regarding market timing or individual stock selection.
The bottom line is this: with a portfolio structured with index and structured funds, diversification is all about diversification of the assets, not diversification of the managers.