Reaping the rewards of diversification

Posted by Liz Rees in Portfolio management category on 07 Dec 15


diversification

In our earlier blogs we have looked at the concepts of ‘attitude to’ and ‘capacity for’ risk as well as how fund managers approach investment risks. Now we turn our attention to considering whether your portfolio is appropriately positioned to avoid unnecessary risks.

A recap of what asset allocation and diversification mean

The terms are often used interchangeably although in general “asset allocation” means deciding how much of a portfolio should be allotted to different asset classes such as equities, bonds, property, commodities, and cash. ‘Diversification’ involves spreading your capital within those asset classes and reduces the investment specific risk. However, you may also hear of a portfolio being diversified at two levels; between asset classes and within asset classes. For example, equities (an asset class) can be diversified further by geography and company size (features of the asset class).

Investing entails taking on a degree of financial risk with the aim of generating higher returns than are available on cash deposits. The objective of diversification is to maximise those returns while minimizing the potential risk based on an investor’s time frame, risk tolerance, and long-term investment goals. Usually, the asset allocation process achieves this by combining asset classes that have less than perfect or even negative correlations.

Both asset allocation and diversification are necessary to maintain a healthy portfolio and incorporating both strategies will lessen the volatility in your portfolio and may improve the chances of reaching your investment goals. A well diversified portfolio will invest in a range of assets which will not all be affected in the same way at the same time by market events. So while diversification doesn’t remove risk completely it should smooth returns.

Or in simple terms….

Another way of thinking about it is the ‘Don’t put all your eggs in one basket’ analogy. You allocate your assets by choosing a number of baskets and move your eggs between them over time. Inside those baskets you can diversify further by choosing different sizes, types and quantities of eggs as they won’t all hatch (produce good results) at the same time. The downside is if all the baskets are dropped and most of your eggs crack, for example as happened during the financial crisis. However, normally the risk of dropping all baskets is small and some of the contents will be damaged less than others!

eggs in one basket

So does it work?

Evidence suggests that diverse asset classes perform differently depending on the prevailing economic environment and other influences such as government policies and demographic trends. Even during a global event such as the financial crisis some assets performed well, for example, gold and silver (safe havens) and oil (as Middle East conflicts threatened supplies). Following the crisis Quantitative Easing programmes by leading world economies have tended to push all asset prices sharply upwards. However, as these policies near completion (only Europe is still in the early stages) we are seeing a return to greater volatility in stock markets which makes having a well balanced or diversified portfolio all the more important.

This all sounds very complicated- what can I do to simplify the process?

One way an individual can diversify their risk is to invest in a fund. This provides exposure to a greater number of shares than many people could afford to hold or have the time to manage. The Fund Manager benefits from economies of scale when dealing, can specialize in a particular area and enjoys superior access to companies. The constituents of a fund may range from a concentrated number of shares up to the entire index as in the case of a tracker fund. Funds which hold a large number of stocks will be inherently less volatile and the beta (a measure of volatility, or risk) of a tracker will be at or close to zero because it replicates the index.

In our previous blog on risk, we looked at how fund managers deal with and manage risk. The large investment houses devote significant resources to the investment process. As well as fund managers they often employ teams of company analysts, along with economists, market strategists and quantitative analysts who can react quickly to the vast amount of corporate and economic news flow which hits their screens on a daily basis. They will work together to analyse the bigger picture and form longer term views on the direction of markets.

Many investment teams operate on a global basis and often have analysts based in key markets to maximise local knowledge. Hopefully, all this work will enable them to identify the best companies and screen out those with poor prospects. Unsurprisingly ,this requires a great deal of time and effort, the cost of which is reflected in the Annual Management charge, and is why most investors choose the fund route rather than building a portfolio from scratch themselves. A passive fund does not incur this additional input and therefore is a cheaper alternative.

Can the Fund Manager deal with Asset allocation and diversification for me?

By buying into a fund you are delegating some degree of risk management. The extent of this depends on the nature of the fund which can range from a general to very specialist mandate. If you choose a multi-asset or multi-manager fund you are entrusting a greater part of the risk diversification to the manager and in most cases can expect to pay a little more for this additional service.

Some multi-asset funds often offers portfolios linked to risk profile: you select the most appropriate fund from a range covering cautious to adventurous appetite for risk. Others present their ranges by targeted returns, for example inflation +3%, which may be suitable for investors seeking reliable income generation. However, the strategies adopted by these funds can vary considerably and it is important to select one which meets your requirements.

Multi-asset funds will tend to give you broad exposure to different asset classes and geographies and will use their expertise to switch between these as and when they believe appropriate according to market conditions. They draw on the expertise of different areas across the investment company and are a popular offering from insurance companies. Many present themselves as suitable products for retirees as they generally offer lower volatility and therefore risk. However, the potential for high returns is not as good. There have been a lot of recent launches which do not yet have 3 year track records. Those with the longest track records include ranges from Henderson, Old Mutual and LGIM. Charges are usually controlled by making the underlying investments in either passive funds or in-house active funds where possible.

Multi-manager funds, on the other hand, usually have a more specific geographical remit such as Global, European or Far Eastern and select what they believe are the best active managers in these areas. These tend to be more expensive than multi-asset funds as you have two layers of charges; the fund manager of the portfolio, and the charges of the underlying funds. These may be slightly higher risk than multi- asset funds but some have generated impressive returns. Jupiter, for example, has a good, long term record in this field.

Another type of fund worth mentioning is target absolute return. They have become popular of late and are aimed at the cautious investor whose main concern is not to lose money. However, most seem to make small losses in falling markets. Extra care should be taken when researching these funds due to the considerable variation in strategies adopted with some making extensive use of derivatives. As a result performance has been very diverse across the sector.

Is asset allocation really important- or can I stick with the UK funds I know and trust?

Some financial experts believe that careful asset allocation is the most important decision that you can make with respect to your investments; even more important than the individual investments you make within an asset class. An appropriate allocation that matches your risk tolerance can help you obtain the rate of return necessary to achieve your investment goals while limiting volatility.

The process of determining the mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will largely depend on your time horizon and your ability to tolerate risk. You may even have a series of investment plans, some of which you are prepared to take more risk with.

So what‘s left for me to do?

As we have explained both an individual and a fund manager need to take account of risk when making their investment decisions. So an investor in a fund is already achieving a certain amount of diversification or spreading of risk. Of course the fund manager, while keeping to a defined investment mandate, does not know your personal circumstances and risk profile and particularly if or when things change in your life. He is dealing with some or many aspects of risk but does not know what is suitable for you: your time horizon, attitude to risk, goals. You may also wish to include ethical considerations, avoid particular countries or above all minimise costs.

Just as a fund manager will closely scrutinize the track records and abilities of the management of the companies he invests in it is similarly advisable that fund investors assess the managers of their money in much the same way. Pay attention to his stated objectives and the style they adopt to achieve them. Some adopt a bias to growth, some focus on ‘value’ investments while another group uses a blend of both. Some fund managers operate a concentrated portfolio which they have very high conviction and stick with for many years. Others invest in a wider universe and may trade more frequently. So it is important to check that your fund choices have stuck to their mandate and investigate the consistency of performance delivered over the long term.

I want to make my own asset allocation decisions: How can Willis Owen help?

Willis Owen provides several tools* to help the self-directed investor research and construct a portfolio suitable for their needs: Fund Space, Share Space, Play Space, Your Space and Other Assets.

Tools

An investor who prefers to take a greater role in asset allocation can build a portfolio from the wide range of actively managed funds which are available. These range from generalist global funds to highly specialised funds by sector, such as JP Morgan Natural Resources, or by country, for example Jupiter India. You can select those which suit you best from a wide range of funds offered through Willis Owen by using our Fund Space research tool.

Furthermore, if you wish to hone your investing skills before constructing your portfolio our Play Space facility lets you ‘try before you buy’.

It is particularly important to read the fund objectives to ensure they align with your own; these can be found in the KIID (Key Investor Information Document) which also gives give some guidance on the risk level of the fund. Additionally, take note of the risk rating which has been assigned to the fund by FE which uses a quantitative measure of standard deviation relative to the FTSE 100. The overall fund ratings from our research partners Square Mile take a more qualitative approach but also pay close attention to Fund managers risk attitude and whether it is compatible with achieving the stated objectives of the fund. These can be viewed when researching funds in the Fund Space service.

Your Space is a service where you can view all your holdings with Willis Owen in one place and consider your asset allocation, even if you have a series of ‘pots’ for different savings goals. Furthermore, if you hold other investments elsewhere you might like to use our ‘Other Assets’ tool to provide you with an overall picture of your wealth.

Don’t forget to review your asset allocation on a regular basis

It is very important to reassess your risk profile as your time horizon and investing objectives change to ensure your portfolio is appropriately diversified for your current circumstances. If some areas perform much better or worse than others then your asset allocation may become out of line with your investment goals which themselves may change over time.

Therefore revisit your asset allocation regularly and check it is appropriate for your needs and adjust if necessary. Experts recommend this should be done every 6 to 12 months and it is also a good idea to check on the performance of each holding at the same time to ensure they are meeting their objectives and deserving their place in your portfolio. You may wish to divide your savings into pots each of which can have different risk profiles.

*Tools to assist in research:

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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