Diversification can limit rewards

 
Philip Salter
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IT’S A truism of investment advice that an investor should be diversified. And for good reason – only a gambler would put all his money in a single equity in the hope of striking it rich. Yet it shouldn’t be forgotten that diversification comes at a cost – one that should be weighed principally against time horizons.

VARIETY IS THE SPICE
Some diversification is a must. Rob Burgeman of Brewin Dolphin readily admits that if he had been forced a couple of years ago to pick a single stock for an investor, he would have likely gone for BP. He says a few years before that it would have been rational to pick Lloyds TSB. Picking a variety of equities exposed to different movements in the economy is essential (either directly or through an index), but you need to go beyond stock diversification to asset class diversification.

However, Andrew Humphries who is executive director of asset management at St James’s Place notes that correlations across asset classes have been increasing over the last few years: “If one looked at 2011, the equity markets were dominated by the ‘risk on’ ‘risk off trade’, when most stocks in the market either all went up or down in unison dependent on the latest piece of macroeconomic news or statement from political leaders.”

Although equities and other assets took a tumble in 2010, not everything fell as far, as fast or for as long. Bonds bounced back, proving the case for a diversified portfolio across asset classes.

Attempting to avoid correlated assets through diversification has its limits. Burgeman explains that in trying to minimise the peaks and troughs (the risk) investors can be left on the sidelines in a bull market. He also notes the danger of holding inversely correlated assets: there is simply no point as gains cancel out losses.

Avoiding all risk reduces the scope for rewards. Burgeman uses the example of hedge funds – many of which have failed to live up to their claim of delivering absolute returns – it’s no good being uncorrelated if you aren’t providing the returns.

THERE IS AN ALTERNATIVE
Beyond the classic 50 per cent equities, 40 per bonds and 10 per cent cash ratio, the finance industry is coming up with increasingly imaginative ways to try to minimise the risk of a rare event destroying an investor’s wealth.

This search for the Holy Grail will never end. Hedge funds, commodities, futures contracts, derivatives, private equity, real estate or collectibles are being used to attempt to ride the wave. For example, Doric Nimrod Air One, a closed-ended company which listed on the LSE’s specialist fund market, purchased one Airbus A380-861 aircraft and leased it to Emirates Airlines. Its investment objective is to obtain income returns and a capital return for its shareholders. Burgeman explains that so far investors haven’t done too badly, up from 100p in December 2010 to 117p and a half, providing a 7.6 per cent yield. Although you wouldn’t want all your wealth invested in this flight of fancy, he sees no reason why investors shouldn’t have one per cent. Coming back down to ground, Burgeman also likes the 3i Infrastructure fund and the HSBC Infrastructure fund – both yielding 5 per cent.

TIME IS MONEY
Gold is worthy of consideration as an alternative asset, not least because its behaviour exemplifies a vital variable when thinking about how to diversify: time. Throughout history the yellow metal has proved a fantastic store of value. Ignore the nonsense about it being a 6,000-year bubble – while paper-backed money has collapsed time and again, physical gold has held firm. Yet it has had its ups and downs. If you’re a gold bug and retire on the down, you might be struggling.

Indian families have the right time horizon: gold’s volatility means that it is something to pass on physically through the generations – used only in cases of emergency.

Gold, or any asset for that matter, only gets you so far; but equities are likely the best bet for those with time on their hands who need to realise their investments in their lifetime. But it’s all about timing. James Butterfill, an equity strategist at Coutts, says “for the long-term investor, it is essential to avoid over-priced assets – while diversification is essential it must not be implemented without consideration of valuations.” He explains that given the scarcity of assets with a yield above inflation, the hunt for yield requires a step up the risk scale. Therefore, Coutts is overweight high yielding equities, exporting companies to emerging markets that can outgrow their domestic peers and companies in monopolistic positions.

In contrast, those nearing retirement with a shorter time horizon are forced in the main to hold less exciting assets: government gilts and corporate bonds.

Multi-asset funds provide too little reward for risk
MULTI-ASSET funds are simply funds that have the ability to invest in more than one asset class. The logic behind picking a multi-asset fund is obvious: you get the benefit of a manager’s expertise and watchful eye overseeing your asset allocation. And although they aren’t the cheapest investments in the world, the powerful fund providers are able to offer a decent total expense ratio – by combining access to multiple asset classes in a single fund unit. However, you should look before you leap. Some are multi-manager funds which may be fettered with the fund house’s own offerings And despite the buzz of activity surrounding them, research from InvestorBee suggests that by selecting a multi-asset fund many investors are not receiving a fair reward for the risk they are taking on.

Driven by data from DCisions, InvestorBee is able to analyse more than 1m real consumer portfolios, defining five distinct levels of risk – with corresponding performance benchmarks based on the average outcomes of real investors. From this, InvestorBee is able to quantify the vital dimension of risk when measuring a fund’s relative performance, helping investors better understand the risk they’re taking and whether the fund is delivering you value for that level of risk.

InvestorBee allows investors to see whether funds have destroyed value – including the impact of fees – by comparing its return with the average return achieved by real investors taking the same level of risk. This arms investors with the facts to make sure that a fund’s track record backs up its claims. It’s interesting to see how many multi-asset funds underperform by a such a large margin on a risk adjusted basis – outsourcing asset allocation is a very tempting offer but it’s hard to know who to trust.

However, not all multi-asset funds should be tarred with the same brush (see tables above, right); it’s just that investors shouldn’t put blind faith in their multi-asset manager’s ability to deliver the right blend of assets. InvestorBee’s founder Graham Mannion observes that “multi-asset funds make a lot of sense, however investors should remember that selecting a fund is a tricky business – you have less than a one-in-two chance of picking one that will match or beat its InvestorBee benchmark.