By Imraan Jakoet, 30 January 2013
Blending funds managed by different investment houses/managers, who subscribe to different investment philosophies and processes, significantly increases the level of diversification within the portfolio and ultimately improves risk management.
In this article we look at the benefits of blending a select group of funds into a portfolio and will highlight some of the key aspects to consider when selecting funds.
Choosing unit trust funds has become part science and part art as one can never know how a fund will perform in future based on past performance. It is important therefore that your selection process is driven by a structured process, which not only favours funds with a good recent performance history. The process should ultimately look to identify quality funds which will put you in the best position to reach your investment goals. Once you determine which funds are best suited for your portfolio the aim should be to select funds which will effectively complement each other.
One of the best places to start your blending process is first to clarify the asset manager’s investment philosophy and process. Do they follow a value or growth philosophy? Does the fund benchmark itself against peers, inflation or an index? Do they forecast what is going to happen in the economy or do they focus solely on company valuations? It is not necessary to understand exactly how investment decisions are made but what is important to understand is whether their views will tend to differ significantly or not. Managers who follow dissimilar approaches tend to produce different types of performance over different market cycles. Differences in investment approach usually result in the managers constructing portfolios which hold different shares and fixed interest instruments and that position asset allocation differently.
Funds with a benchmark like the FTSE/JSE All Share (ALSI) tend to hold shares which would cause them to at least perform in line with the ALSI. Multi-asset funds with an inflation-plus benchmark would hold assets/instruments which would protect capital against the risk of inflation. The benchmark therefore guides the manager on the types of instruments that would be appropriate for the fund to meet its benchmark objectives. Funds in the same category however often follow the same benchmark so this isn’t always a differentiator.
Comparing past performance is a good way to go about this but again this does not guarantee that the funds will perform in a similar fashion going forward. A useful statistical measure to look at is the correlation coefficient, which is simply a measure of how similarly two things move relative to each other. A correlation number of +1 indicates that two funds move together perfectly while -1 indicates an exactly opposite relationship. Funds which prescribe to different investment styles tend to have lower correlation numbers (or even negative correlations in some cases). Lowly correlated funds will typically be better suited for blending into a portfolio.
Once the correct funds are selected for your portfolio you will over time notice some distinct features relative to single funds. A blended portfolio displays lower levels of volatility than a single fund and would typically protect capital better than most of its competitors. The lower volatility also results in the portfolio displaying a smoother performance profile, avoiding any nasty performance surprises. Another important point to note is that because blended portfolios are typically an average of their underlying funds, the blended portfolio will never outperform all of its constituents. It will however never be the worst performer either.
Blending funds may have many benefits, but it is important to not over-diversify your portfolio. Selecting too many funds dilutes the benefits of diversification and can, in some cases, increase the risk of your portfolio. The focus should therefore remain on selecting a handful of quality funds which can complement each other. As a general guide, try to stick to four – six funds.
Not only will blending funds reduce your asset manager specific risk (i.e. the risk of them getting something very wrong), but if done correctly has the ability to limit volatility and losses/drawdowns over time and as a result can provide a smoother performance profile. As an investor you also have the comfort in knowing that your fund performance isn’t dependent exclusively on one investment house and that your portfolio is structured to deal with different market events. Doing all the homework on unit trust funds may not suit all investors as there is a risk of selecting funds which are simply inappropriate for the portfolio. It is therefore advisable to seek the guidance of a good financial adviser to assist in the selection process.