HERE’S a problem shared by many private investors. Over the years, holdings have been built up in a range of funds and trusts.
The holdings are scrappy, disorganised, difficult to keep track of and in need of discipline and concentration. But, instead of weeding out and simplifying into a handful of investments that we can reasonably manage, investors keep adding new ones.
We do this because it is battered into us that we must pursue diversification. The wider the spread over different funds and trusts, the more our risks are spread and the lesser likelihood of suffering a painful loss. Diversification may mean we forego a stunning performance that we might have got if we had made the right choices and had concentrated our investment in just two or three funds or trusts.
But “the right choices” prove elusive. Better to have a wide spread of holdings and to provide a cushion of reassurance in downturns.
So much for the theory. Unfortunately, in the experience of many investors, the result is an impressive looking long list of holdings giving the appearance of diversification but in fact little diversification at all.
Take the example of an investor who is biased towards income investment trusts. These are offered by all the investment companies. So it is not difficult to accumulate a portfolio of seven or eight different trusts in the firm conviction that by holding seven rather than one we have achieved diversification and spread our risk.
Quite the contrary is the case. Most of these trusts operate very similar portfolios. And the biggest holdings in these trusts tend to be in a concentrated – and all too familiar – list of shareholdings. Investors soon experience an uncanny sensation of seeing double – or more often triple and quadruple.
Frequently recurring shares in the top ten lists of such funds include BAT, BP, Centrica, GlaxoSmithKline, HSBC, Legal & General, Shell, Unilever and Vodafone. The top-ten holdings typically account for between 20 and 30 per cent of a portfolio and are the main determinants of performance.
In the investment trust sector alone there are 22 trusts listed in the UK growth and income category. And it is not uncommon for private investors to hold a number of these.
Of course, they are not totally identical. There are variations down the portfolio list. The shares of the big companies may have been bought at different times and the size of the holdings varies from one trust to another. And the managers may adopt different buy and sell strategies. But the underlying list of top-ten holdings is still very similar.
The illusion is that the more trusts that are held the greater the diversification. In fact, all the investor has achieved is ever greater concentration in a small number of big companies.
How can investors avoid this inadvertent concentration – the opposite of what they set out to achieve? There’s the obvious first step of checking the list of investments held by these funds and trusts. The top-ten holdings can be easily viewed on websites and on company literature.
There may still be case for holding more than one trust in the same sector if there is sufficient divergence in management style and approach to justify an additional holding.
For those investors too time-pressured to do this, fund market research and analysis company Morningstar provides a portfolio x-ray tool that effectively does this on investors’ behalf.
If, for example, three different funds in the investor portfolio each own a share, this useful gadget will show you how much your total allocation to the stock is worth and what percentage of the portfolio’s net assets it represents. The tool also shows you which funds are providing exposure to which stocks and how much each position is worth. This can come in handy if you decide you want to reduce your exposure and are wondering where to cut back.
Once investors have established where the duplications are, the process of slimming down can begin. It may be that, as a result of this exercise, investors find they would be better off holding just one low-cost income tracker fund and perhaps one managed fund where there is a track record of sustained superior performance.
This exercise needs to have regard to the investor’s overall preferences and requirements, and a simple asset allocation model devised. For example, in investor still wishing to have a share portfolio biased towards income holdings, could choose to allocate, say, 60 per cent of their available funds to an income tracker fund plus one income-orientated managed fund or trust.
The remaining 40 per cent of the portfolio can then be spread over different categories – technology funds for example, or smaller company funds or emerging markets. But here again the investor needs to take care over duplication.
It pays to ensure portfolio diversification really is just that – and not an optical illusion that on close inspection leaves you seeing double – or treble.