Diversification thwarted if your investments overlap

Diversification is the key to reducing investment risk, but you need to be careful: when investing in more than one unit trust fund or other pooled investment, do not inadvertently overlap the underlying investments.

The diversification of investments across asset classes such as shares, properties, bonds and cash is a sound strategy, but overlapping or replication of the underlying securities can reduce the impact and the benefits of diversification, dampen returns and add to the cost of your investments, says financial adviser of Discovery Invest, Claire van Wyk.

The four biggest balanced or multiasset funds in South Africa share similar objectives and strategies and, when their beforefee performance is compared, their returns are similar over the long run, she says.

Van Wyk says she regularly encounters investors with overlapping or replicated investments.

“I see investors with three balanced [multiasset] funds from different asset managers, but the underlying stocks are very similar. Because of South Africa’s small investable universe, many balanced funds’ top 10 holdings will include shares such as Naspers, BAT and a handful of financial stocks . . . These investors are replicating a significant part of their investments, effectively reducing the benefits of diversification.”

Balanced funds are a popular investment choice as they offer a relatively smooth ride to returns that, over the long term, are similar to those you could achieve by investing in equities.

Find your facts in fund sheets

They are also popular among retirement annuity and retirement fund investors as they adhere to the prudential investment guidelines under the Pension Funds Act, relieving you of the work involved in ensuring that your choice of funds meets and remains within the guidelines.

When investors or inexperienced advisers choose similar funds from different providers, believing they are diversifying, and without drilling down into the underlying stocks, investments can overlap.

Van Wyk advises that investors and their advisers research the equity holdings of the funds they hold by examining the fund’s fact sheets.

These fund fact sheets typically reveal the top 10 holdings for the past quarter.

Apart from diversifying across asset classes, it is important that investors diversify across geographic regions and asset managers to avoid being invested in funds that have similar objectives and investment strategies, Van Wyk says.

How to fight market sentiment

Adriaan Pask, the chief investment officer at PSG Wealth, says diversification of your investments is the most efficient strategy to mitigate risk because you do not necessarily have to sacrifice returns to reduce potential risks.

You can therefore significantly enhance your risk-adjusted returns if you understand the key return and risk attributes of various asset classes and securities, or even the impact of currency effects by diversifying geographically, he says.

Pask says different asset classes and different securities can behave in very different ways, each offering a unique return signature or profile.

If you know how to combine them to enhance returns, you can create a portfolio more valuable than the sum of the individual parts.

In a well-diversified portfolio, you can avoid the situation where a specific stock can compromise the success of the overall solution.

Pask says using pooled portfolios such as unit trusts makes diversification a widely accessible, cost-effective benefit, where previously diversification might have been costly to implement for smaller investors, or investors did not have access to international markets.

Jeanette Marais, a director at Allan Gray Investment Services, says the recent downgrades of South Africa’s foreign and local credit ratings by more than one international ratings agency highlight the importance of having a diversified portfolio.

If your portfolio contains well-diversified businesses whose earnings are generated offshore, as well as local businesses that can withstand market shocks, you are best positioned to withstand the negative market sentiment that follows events such as a downgrade, she says.

Focus on the long term

Bruce Fleming, a financial planner with Old Mutual Private Wealth Management and former winner of the Financial Planner of the Year, says you need to focus on the long-term financial goals, diversify appropriately and be guided by valuations.

“As investors cannot predict markets, diversification is key in achieving investment returns,” he says.

Fleming says that political and macro events can affect short-term volatility, but investment fundamentals and a sound, longterm investment framework will essentially drive returns and performance.

“In the short term, emotional decisions have a tendency to erode wealth, which can take years to correct. Instead, it’s all about having clear short-, medium- and long-term investment goals.

“The important thing to remember is the longer the time period of the goal, the more risk an investor is able to accept.

“However, regardless of the timeline, any underlying investment should be part of a well-researched, diversified portfolio that can map returns against the investor’s financial objectives,” Fleming says.

How can you properly diversify your investments? Read Part 3 of the Money Guides on investing, live on our website today. The Money Guides are a series of educational articles written by Money’s writers and made possible by sponsorship from Discovery Invest