Fine-tune portfolio diversification with the family tree of investing

2011-05-21 00:00

THE size of South Africa’s total listed-company universe means that local stock-market indices are dominated by a handful of large companies. As a result, many local asset managers with broad equity mandates may be forced to hold certain shares simply because of their index weightings, often with little difference in the shareholdings of two funds in the same category.

We typically see quite a large overlap among the top shareholdings of asset managers in the various equity sub-categories. Funds with similar benchmarks can easily overlap by more than 50%.

It is this overlap that can expose private investors with too many actively managed unit-trust funds to the threat of closet indexation.

Closet indexation occurs when an investor buys such a wide range of investment funds that he or she ends up with the market return. The more funds you put into your collection, the more your net performance resembles that of the overall index. And that’s not the outcome you expect for the extra fees you pay your active fund-management team.

While the investment return from an actively managed fund is a function of the skill of the manager, as well as the manager’s ability to translate his or her market insights into the portfolio construction, it is the breadth of the opportunity set that is essential. Asset managers will be most effective with the fewest possible constraints.

Instead of focusing only on asset allocation or money-market funds, investors need to consider opportunities from the different branches of the family tree of investing — represented in the unit-trust space by categories such as offshore, equities, property, fixed income and asset allocation.

The “family tree of investing” concept refers to a mathematical technique where funds with similar performance profiles are grouped. This usually produces clusters of funds with similar underlying asset exposures and performance drivers.

The family tree offers deeper analytical insight into returns across asset classes than the familiar Asisa (Association for Savings and Investment SA) fund categories.

By analysing the overlap between funds and portfolios in terms of performance and actual shareholdings, I believe the best way to attack closet indexation is to implement an appropriate diversification strategy. But diversification cannot be achieved by buying an endless succession of asset-allocation funds. Choosing multiple funds offering similar strategies is not proper diversification.

A carefully structured selection of dissimilar funds diversifies a portfolio and spreads the investor’s risk. A idea is to use a multi manager fund. Multimanager funds offer a degree of diversification that is not easy to achieve in a single-manager fund.

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