Diversification the key to portfolio stability

The choices advisers face when building an investment portfolio can be a lot like the choices developers face when building an office block.

By specifying one particular sector class, asset class or style, advisers are basing all their clients’ cash in a small solid space, hoping their superior understanding of investment markets will send returns sky high.

By diversifying, an adviser will spread their client’s money as wide as possible, increasing stability and decreasing the risk of a collapse if that smaller space should turn out to be on shaky ground.

Unlike developers, it is unusual for financial advisers to take the first approach.

Zenith analyst Ben Davis says his first priority when constructing a portfolio for his clients is choosing the best fund managers — usually those who have consistently performed 2-3 per cent higher than the average. But this doesn’t mean he will start building in a smaller space. Rather, Davis will diversify across sector, asset and asset style, with the scope of diversification increasing with the amount of money invested.

If a client had $200,000 to invest with a $40,000 allocation to Australian equities, Davis would use two or three Australian share managers with one heavily indexed. But if a client had $500,000 he might use a value/growth core, two or three satellite managers and a long/short manager.

He doesn’t recommend styles should be weighted either way.

“If you’re too heavily into one particular style you can have long periods of under performance if growth managers are running or value managers are running.”

He says diversification means the investor can enter a portfolio at any time and expect it to outperform, whereas with a strongly styled portfolio, investors run the risk of entering the market at the wrong point in a cycle.

Davis says Zenith will avoid using tactical allocation but will provide strategic asset allocations that are re-weighted on a quarterly basis.

“What we don’t do is try to pick markets and tactically change sector allocations over short periods of time. Studies that we’ve done have shown that it’s very hard to add value through that source.”

Aegis Equities Research head of managed investments research Angela Ashton agrees it is best to balance asset allocation styles because “the markets are just too unpredictable”.

She says it is also important for advisers using three or less fund managers to take care not to use any deep growth/value funds as they could end up with investment biases. Ashton says by going up to five managers this bias will be eliminated.

“If you start building a portfolio out to five fund managers you can start putting a deep growth fund in and putting in an appropriate deep value without blowing your tracking errors. That allows you to end up with a portfolio that might have a more acceptable tracking error as a whole and still pick up the outperformance from that particularly deep style.”

Ashton says her ideal portfolio would contain a combination of five core managed funds, two growth, two value and one blended growth/value neutral. These would account for about 70-80 per cent of the portfolio. The other 20-30 per cent she says should be put into satellite funds that offer alternative investments like hedge funds and small caps.