The power of diversifying across investment styles

Andriette Theron, Senior Investment Analyst at PPS Investments.

Investors are often told to diversify their risk across asset classes, sectors, geographies and currencies, but diversifying portfolios to include complementary investment styles is rarely mentioned. When market fundamentals change significantly, style diversification can be particularly important.

Certain investment approaches, such as multi-management, aim at delivering more consistent performance over time by combining more than one manager, and consequently exposing investors to more than one investment approach. By its very nature, the multi-managed fund should be more consistent than the manager that follows just one style.

Combining managers with different styles can thus help to reduce the exposure of portfolios to any one particular view. Different asset managers could have very different views or positions on the same share.

These different investment styles perform differently during various market cycles. The value focused style for example could underperform when the market gets increasingly expensive (like in the past couple of years), but should hold up better when valuations become more important (which is often the reason for a correction).

An investor for instance that is only exposed to one particular investment style may have to live with severe underperformance during certain periods when the strategy is out of favour. Of course, provided the investor can stick with this manager through consecutive years of underperformance, the investor could also ride the wave of outperformance when the manager’s approach is rewarded.

Unfortunately investors find it difficult to stick with a manager whose style happens to be out of favour, and that investor can often try to chase past performance. This could lead to an even less desirable outcome as the investor could end up participating in the downside of the subsequent weakness after not experiencing any of the upside of the recent past performance.

It is equally difficult knowing which manager will do well beforehand. A manager that outperformed because of a large position in a particular share in the past, might not repeat its outperformance should that same share underperform. Past performance is no guarantee of future performance, and on occasion it can be a very poor predictor. This is especially the case when market conditions change.

The current environment is particularly challenging as the market is unsure both about global growth and the impact of more US interest rate hikes this year, and this is resulting in significant volatility across investment styles.

The approach of combining managers with different styles requires the investment manager to have a very deep understanding of each underlying asset manager’s strategy, because it is very important that the manager sticks to its style. It would be highly problematic for instance if a value manager included in a portfolio suddenly decided to buy an expensive growth share to keep pace with its benchmark in a period that it was underperforming, as this would expose the portfolio to too much momentum style risk.

Importantly, multi-managers do not try to pick the top-performing manager, but rather to combine managers with sensible strategies who are having an edge in terms of generating outperformance. They look for as many sources of returns as possible, while acknowledging that the future is uncertain and is likely to surprise.

Saving for one’s retirement or other important financial goals can be an arduous endeavour that requires discipline and commitment. A multi-managed approach could help investors to achieve a more consistent return profile over time.