By Craig Martin
In an article published about three weeks back, I raised a few controversial issues that may have been considered blasphemy to advocates of modern portfolio theory. One of the assumptions often made is that risk is associated with “volatility” or “standard deviation.” In order to reduce the “standard deviation” in a portfolio, fund managers typically add additional uncorrelated (or low correlated) assets to the portfolio, to diversify away the risk.
The proposed alternative argument is that this strategy also diversifies away the potential returns. Essentially it is an argument between a “search for quality” where you have a very focused or concentrated portfolio, often “bottom-up” selection, versus modern portfolio theory methods, such as the efficient frontier model, which supposedly assists portfolio managers in achieving the ideal risk/return trade-off.
Rudi van Niekerk, whose podcast was linked to the previous article, rather defines risk as “the likelihood of loss of permanent capital” and is happy to hold five or six shares, trading-off volatility for return. Some argue that van Niekerk runs a relatively small fund and the rules would not apply if you are a large pension fund manager. This question was also raised by Lindsay Williams in an interview discussing the original article (see Video below).
So, I thought that we could further this debate by examining the investment philosophy of some of South Africa’s large fund managers.
In response to Lindsay William’s question and in the original article, I made mention of the Coronation Top 20 fund, which is extremely focused and holds between 10 to 20 shares. Although this is the most aggressive of Coronation’s equity funds (by their definition of standard deviation) it has also achieved consistent top quartile performance and has outperformed their in-house stable of more diversified funds. This is not conclusive, but it could be a good argument that holding a handful of high-conviction opportunities will provide better returns than simply diversifying for the sake of reduced “volatility”.
The fact is that some fund managers are too large to hold an extremely concentrated portfolio of 5 or even 10 shares. However, there are some asset managers who recognise that there is less need for diversification when you have great conviction in your research.
“Diversification is protection against ignorance,” wrote Warren Buffett, who added that “diversification makes little sense for those who know what they’re doing.” Foord Asset Management calls “diversification” “the chance to manage the risk of being wrong”, but adds that “where careful analysis gives an investor greater conviction, less diversification is needed – because the risk of being wrong is lower.”
On the other hand, RECM are supporters of “diversification” and refer to it as being “an excellent and proven way to reduce the risk of financial disasters” and they point to “correlation” as being the key ingredient that makes diversification work.
Research was undertaken by Alexander Forbes on South Africa’s Large Fund managers performance and volatility for the 3 and 5 years to the end of September 2014. It is interesting to note that Foord is the domestic large fund manager that managed to achieve the highest overall returns over those periods, but they achieved this with the second highest “standard deviation”.
The scatterplot (as shown above) shows that although RECM had by far the lowest volatility in their domestic funds, but also ranked by far the last in terms of performance. Granted, this might have more to do with their “deep-value” strategy than purely diversification or focus on “standard deviations.”
I must concede that Investec accepted a lot more “volatility” than Allan Gray to achieve only marginally better performance, whereas Coronation had only a marginally higher “standard deviation” but managed to still achieve the second-best overall returns. This is not a conclusive case study and the sample is really just eight asset manager funds.
RECM does add in one of their newsletters that “a portfolio that is well diversified will sustain its value during market declines much better than one that is not. The result is a portfolio that is rarely the top performer of the year.” However, the point of having a focused portfolio is that you want to achieve “alpha” over three and five years, even if it means that there will be periods of volatility where your funds drawdowns may be higher than your more diversified peers.
As a caveat, risk tolerance of investors varies, and while focused funds can create additional returns for your portfolio; putting all your eggs in one basket could also expose you to great losses. However, I would argue for the view that you can diversify if you are happy with beta and focus if you are chasing alpha!
