Why diversification may not be as simple as choosing a few fund managers

How correlations can assist in managing behaviour.

Ingé Lamprecht  |  17 August 2016

 JOHANNESBURG – Speak to a financial advisor and chances are he’ll tell you that a large part of the job is about managing expectations and emotions.

And if one considers that markets are driven by greed and fear and that investors often struggle to deal with losses during periods of turmoil (or may suffer extreme Fomo throughout the last tremors of a bull market), it is easy to understand why. It can be very difficult to stay the course when the ride gets bumpy.

One way of getting investors to stick to their long-term investment strategy, is to construct a portfolio in a way that delivers a more consistent return through diversification. Following the global financial crisis the popularity of multi-asset funds has grown considerably as they do not only offer the opportunity to move asset allocation decisions from the financial advisor to the portfolio manager, but generally often also offer a smoother ride. Investors tend to get most of the upside of equity-only funds, but most often don’t experience such an extreme drawdown when the markets tank.

But, says Dale McCarthy, marketing and client relationships analyst at Rezco Asset Management, the fact that investors choose different fund managers that provide diversification with regard to management teams and styles does not necessarily guarantee that the portfolio is diversified.

The South African equity market is fairly concentrated with a relatively small basket of shares to choose from and while investors may have invested with two or more different managers, there may still be quite a large overlap in their holdings.

“Just because you have different management teams and styles doesn’t mean that you are going to necessarily pick a different stock, you might just pick a different weighting in that stock.”

This means that the funds used to construct the portfolio could perform in a similar manner – in other words, outperform or underperform at the same time, which could trigger an emotional investment response – buying high or selling low.

McCarthy argues that by blending high-quality funds that are less correlated to one another in a portfolio, one could reduce the volatility of the portfolio return and limit the probability of an emotional investor response.

“With these less correlated funds you are probably less prone to pull your money out at the wrong time.”

Correlations

Where the returns of two funds move almost in lockstep, the funds are highly correlated, McCarthy explains.

“So the closer you move towards a positive one correlation, the more correlated your funds are, the closer you move towards zero, the less correlated your funds are.”

Andró Griessel, managing director of ProVérte Wealth and Risk Management, says in the long run, assuming you invest in similar asset classes and use equally skilled managers, lower or higher correlations between these funds won’t necessarily lead to different return outcomes, but it can be useful to reduce the risk in the portfolio – not the risk of permanent capital loss, but the volatility of the investment.

Where assets with low correlations are combined in a portfolio, the return profile of the portfolio is likely to be much less volatile and generally easier to stomach for the investor.

Griessel says value managers tend to construct concentrated high conviction portfolios, which could create a very bumpy ride for investors. For the Average Joe who may not understand the investment philosophy of such a fund, this may not be the right choice as there will likely be times when the fund suffers significant and prolonged periods of drawdowns, which could move the investor to sell at a low point, just before the fund shoots the lights out.

A good example from the recent past is the Investec Value Fund. It delivered 86% over the past year, but returned -26% in the year before that. Many of the investors who were in this fund two years ago could not stomach the drawdowns and sold out at the most inopportune time and subsequently missed the massive recovery. Although the investment’s outcome over the 24 months is comfortably ahead of the Alsi’s, the return experience of investors in this fund might have been completely different due to them not being there for the full period. By reducing correlation in a portfolio you might slightly reduce your total investment return but by providing the end investor with a smoother ride, you enhance the chances of a better investor return, he argues.

Combining a fund like Investec’s Value Fund with another fund with a completely different style, and hence a low correlation to each other, is an effective way to ensure a much smoother ride for the investor, he adds.

While two high equity portfolios with completely different styles might offer investors a similar return over a ten-year period to any of the individual underlying funds, by having both in your portfolio you should end up with a smoother/less volatile return and by doing that hopefully help the client to not make irrational decisions on the back of high volatility, Griessel says.

This article is a general information sheet and should not be used or relied on as financial or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

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