Fine tune portfolio diversification with the family tree of investing

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.

This phenomenon is clearly illustrated by the fact that the 42 largest companies listed on the JSE All Share Index comprise 85% of the total market capitalisation. 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 unwittingly 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 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 least 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 particular mathematical technique where funds with similar performance profiles are grouped together. This usually produces clusters of funds with similar underlying asset exposures and performance drivers, much like the branches of a more conventional family tree.

This method represents a more powerful way of categorising and classifying different funds and fund managers. The family tree offers deeper analytical insight into returns across asset classes than the familiar ASISA fund categories.

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

A carefully structured selection of dissimilar funds diversifies a portfolio and spreads the investor’s risk. A good way of achieving this is to use a multi manager fund. Multi-manager funds offer a degree of built-in diversification that is not easy to achieve in a single manager fund. Multi-manager funds are structured as a carefully selected combination of managed funds from a variety of fund management houses.

An understanding of the family tree of local investments gives PPS Multi-Managers a much better understanding of the similarity between funds and goes a long way to achieving sensible risk/reward diversification. The family tree concept is a perfect way to improve diversification – and the multi-manager concept is tailored to implement the resulting family tree decisions.