Is Your Unit Trust Portfolio Diversified?
Diversification is one of the most important things we can do for our investment portfolios. Market movements are governed by the emotion of market participants. It is extremely difficult to forecast which way an asset class will move at any time and nigh impossible to know what asset class will perform the best this year or next year or the year after that. This is best evidenced by the following graph taken from the 2017 edition of Old Mutual’s Long Term Perspectives:
With that in mind I would like to share some observations from my work analysing client portfolios as a Para Planner in a Financial Planning business.
Fund Managers South African investment options are limited
In terms of South African domiciled unit trusts, who invest in South African assets, there are only so many options for fund managers. I have heard many numbers used, but for the sake of simplicity there are roughly 300 investable shares available on the JSE (in comparison to the thousands listed on international stock exchanges). Some of the Unit Trust managers are too large to be able to build large enough positions in smaller companies. As an example, if the total value of a fund is R136 Billion. To build a meaningful position in a smaller company they would need to buy a minimum of R1.36 Billion (1% of the fund) worth of stock. R1.36 Billion stock will need to be available in the market for them to do this and with smaller companies this tends to be a problem as large percentages of the companies are owned by individual shareholders in the form of the founders or management. The fund manager may also not want to be the majority shareholder of the company as this would mean that they would effectively control the company. This could be a burden for the manager. This inability to invest in smaller companies means that the large fund manager’s options are further limited to the region of the top 100 shares on the JSE. This is just the share market. Bond, Listed Property and Cash instrument markets are even smaller and more limited.
There is overlap between funds in the same category
With their limited choices in terms of South African asset classes, it is inevitable that there is significant overlap between unit trusts in South Africa, particularly those in the same fund category. Often, a client will come to us with a portfolio where there are multiple funds in the same fund category. Here’s the kind of portfolio we typically see:
20% Balanced Fund A
20% Balanced Fund B
20% Balanced Fund C
20% Balanced Fund D
20% Balanced Fund E
Each one of these funds will be run by a reputable South African asset manager and has a good long-term performance track record. However, this is not a well-diversified portfolio. Each of these funds is a South African High Equity Multi Asset Fund. Each of these funds has the same restrictions in terms of having to comply with Regulation 28 (75% in equities and maximum of 25% in Foreign Assets). Each of these funds is Actively Managed and is looking to purchase assets, that are going to appreciate, at a reasonable price/discount. With this portfolio, we are effectively paying 5 managers to do the same job for us.
Different fund categories, same problem
Another kind of portfolio we see is:
33.3% XYZ Low Equity Balanced Fund
33.3% ABC High Equity Balanced Fund
33.3% DEF Medium Equity Balanced Fund
These are three different managers and three different categories of fund. It is intuitive that this would be a well-diversified portfolio. This is unfortunately not true. There is overlap in the fund holdings, even though each of the funds has different Regulation 28 constraints (40%, 75% and 60% maximum in equities respectively). Using three leading funds as a reference point this has led to similar performance and correlations of 0.74 to 0.87 over the last 10 years. With 1 being identical performance, these funds are too close for comfort. Ideally, we want the fund in our portfolio to be as uncorrelated as possible.
How many funds is too many?
Often a client will have too many funds in their portfolio. This will only serve to dilute performance. Each fund is made up of hundreds of small positions. This is best shown by the following picture of the Allan Gray Balanced Fund:
Having too many funds in our portfolio means that we may be well protected from risk due to the small size of the positions, however we also may not benefit from positive market performance because many of these positions may be too small to truly matter.
A guideline is to have 2 to 4 funds in the portfolio, all pulling in a different direction or doing a different job for us. We can have two funds with the same mandate, but the style or the way they go about achieving this mandate needs to be different.
What does a well-diversified portfolio look like?
If we were looking to control our own asset allocation or exposure: It may work well to combine a Foreign Equity fund with a Local Equity Fund, an Income fund (Local and Foreign Bonds and Cash) and a Property fund. This would give us exposure to both Local and Foreign Equity, Property, Bonds and Cash, with minimal overlap.
If we were looking for broader exposure to an asset class we could invest in different regions covered by that asset class or different sectors in the market. An example is splitting our offshore exposure between a Developed market fund and an Emerging Market fund or combining a Large Cap fund (top 40 shares on the JSE) with a Mid/Small Cap fund (share number 41 downwards on the JSE).
If we are happy to leave the asset allocation decisions to the professionals we could combine an Actively Managed, valuation based, Multi Asset High Equity fund with a Passively Managed Multi Asset High Equity fund. The valuation based active fund will look to buy assets at a discount and hold them for the long term until they reach their fair value, meanwhile always looking for new opportunities, whilst the passive fund will look to mirror the performance of its chosen index as closely as possible. Passive funds tend to be cheaper and the combination would lower the overall portfolio costs. This would theoretically allow the portfolio to perform well in a variety of market conditions. The passive fund would do well when markets are performing well (2009 to 2014) and the active fund has its chance to shine when markets are stagnant or depressed (2014 to present day).
Conclusion
A well-diversified portfolio is one of the best ways to protect ourselves from risk. A CERTIFIED FINANCIAL PLANNER® professional will be able to assist us in diversifying our portfolio appropriately: ensuring that we are shielded from risk and primed to perform in the long term.
In summary:
South African investment markets are small and there is overlap in Unit Trust fund holdings.
Funds in the same category tend to be highly correlated.
Funds in different categories can be correlated too, it depends on their underlying holdings and how they are managed.
2 to 4 Unit Trusts in a portfolio is plenty.
A well-diversified portfolio combines different mandates (Equity Fund, Property Fund, Income Fund), different geographies (Local vs Foreign and Emerging markets vs Developed markets) and/or different styles (Active fund and Passive fund).
Disclaimer: The views expressed in this article are my own and do not necessarily reflect the views of Verso Wealth. This article is not intended as financial advice and I would urge you to consider your risk profile (risk tolerance, risk required and risk capacity), overall portfolio asset allocation and investment time horizon before making a financial decision. I would encourage you to consult with your CERTIFIED FINANCIAL PLANNER®professional before making any financial decisions regarding your investments.
