Diversification dilemma: How many funds should you buy per sector?

"Diversification is protection against ignorance. It makes little sense if you know what you are doing" - Warren Buffett

How many funds should you have in a portfolio? Furthermore how many should you have within the same sector? These are two questions which most investment commentators shy away from. But in this article I will answer the latter question and shed some light on the former. In doing so I will also expose some uncomfortable truths about the fund management industry.

It's war!

DIY investors need to accept that, despite the millions spent on marketing material trying to convince you otherwise, fund managers and the companies they work for don't care about their investors. The thing fund managers care about most is keeping their well paid jobs and their big houses. The fund management companies in turn care about how popular their funds are because the more money they have under management the more they earn from their percentage annual management charge.

Fund managers are benchmarked against their peers. In the world of fund management it doesn't matter how right or wrong you are but how you compare against your peers. If the fund managers lose their investors a lot of money from a bad judgement call then it doesn't matter too much (and they'll keep their jobs) as long as plenty of other fund managers have done as badly.

It's like being in a battle. Stick your head above the trenches (i.e doing something different) you risk getting shot. Your odds of survival are much better if you go 'over the top' as part of an army. Of course there are brave souls who have gone 'over the top' on their own and survived to tell the tale. Trailblazers who've entered folklore and become heroes. Fund management has them (Neil Woodford is one example) but just like legendary battle heroes sometimes their deeds become exaggerated and the true facts are lost or buried. For every manager that goes 'over the top' and returns a hero there are countless more who disappear to be never heard of again.

What this means is that fund managers tend to follow each other when constructing their portfolios. It's true that there are a finite number of companies out there in which to buy shares but there are almost an infinite number of ways to construct a portfolio from them. If you ever sit with a fund manager and discuss their portfolio you will hear them say things like "'I'm underweight financial stocks but overweight utilities."

This is in reference to their benchmark (i.e. the market). But while being aware of a benchmark is not necessarily a bad thing it does mean that decisions become based around it.

So does that mean that fund managers tend to copy each other to keep their jobs, so much so that their fund's holdings just end up mirroring each other? Or in other words do they charge a lot of money to 'actively' run it yet constantly seek to be average? The evidence shows that the answer to both these questions is 'yes'!

Fund managers only care about avoiding the sack and the best way to do this is to follow the herd.

Copycats and correlation

To see whether there is any evidence of this 'herding' going on I analysed the biggest fund sector (in terms of number of funds), to see how managers run their money. In the UK All Companies sector, which contains funds investing in UK companies, there are 248 funds.

It takes some doing but it is possible to track the average performance of all these fund managers over time. This average acts as a benchmark of what the herd is doing. Now if a fund manager is simply following the herd and simply concerned with keeping hold of his/her job then their performance will move up and down in line with the herd (the sector average).

If on the other hand a manager is trying to follow his/her own convictions, rather than the herd, then the movement in their performance will not occur in lock-step with the herd (sector average).

There is a statistical measure that exists to show whether two things follow each other or not and it is known as correlation.

You can work out whether two things are correlated by working out what is known as the correlation coefficient. It is complicated to work out but it is very easy to use. The correlation figure can range between -1 and 1. A figure of 1 would suggest that the two objects follow each other while a score of -1 suggests that as one rises the other falls and vice versa. A score of 0 means that the two assets are not correlated.

So I tested to see how correlated every fund manager's performance was with the sector average over the last 12 months. Or to put it another way I tested how much each fund manager simply followed the herd and copied what everyone else was doing.

The first table below (Table 1) shows how correlated each fund was to the herd. To make it easier to read I've concentrated on the larger funds which are those over £100m in size which reduces the number of funds to 163. In addition I've highlighted those funds that are simply herding in red, those that are making an attempt to be a bit different in orange while those following their convictions are in green.

What you will see is how much these managers simply follow the crowd. Of course there are a number of equity trackers in there (those run by computers to just match the FTSE 100) and these mostly appear in red. What it does highlight is that there are a lot of managers not doing much more than what equity trackers do. So why would you pay more to have a fund manager run a fund when he's not actively doing anything to add value?

The boundaries I've chose for each colour code are probably on the generous side to the fund managers. In truth many of the orange funds could have also been coloured red.

The point is that out of 163 funds only 33 (the green ones) could lay any kind of claim to be doing anything different from the herd

So most fund managers just follow the herd. To truly diversify a portfolio you need to pick fund managers that are doing different things and following their own convictions.

Is being different a good thing?

A fund manager being different is one thing, but does it make investors more money? If you scroll all the way down to Table 2 I have repeated the analysis in Table 1 but this time ranked the fund manager by their investment performance over the last 12 months.

The top performers are at the top and the worst performers are at the bottom. The sector average is in black. Immediately you will be struck by how the top performers tend to be those funds breaking away from the heard (i.e. in green). Around the sector average and below is a flood of red and orange.

The evidence shows that to increase your chances of outperforming the market then you need to invest in a manager that successfully backs his convictions otherwise you may as well just buy a tracker fund and settle for the market average.

Interestingly there are a few managers who have backed their convictions but their convictions have been wrong. An example is M&G Recovery which lost 4.39% over the last year when the average UK equity fund manager made 6.82%! That's a huge amount to be behind. Does that mean it is a terrible fund or that the manager is useless? Well no, it means his convictions were wrong or they don't suit the current market. The manager of that fund is a chap called Tom Dobell whom I've personally listened to talk about his strategy and holdings. He tends to pick undervalued companies and holds for the long term. He is also a former darling of the industry, previously topping the performance tables. However right now his strategy is not working. Industry commentators would argue that you should buy for the long term and stick with him. But why? Already in just 12 months you could have been 10% wealthier if you'd backed a manager who's strategy was working.

Do not feel obliged to reward a fund manager with your loyalty when he's already charged you for the privilege of losing you money. That's reward enough.

The optimum number of funds per sector

The evidence suggests that holding lots of funds within a sector means that you increase your chances of paying over the odds for average performance rather than outperforming the market.

By holding fewer funds you increase the chances of outperforming as your winners have a greater influence on your returns. Clearly that means that your losers also have a greater impact on your profits. The key is to diversify between managers who are not just following the heard. That increases your chances of picking a fund manager who will outperform and reduces the impact of any poor choices.

How many funds is the right amount. Well when I created the 80-20 algorithm I analysed the impact of holding any number of funds. The sweet spot between consistency of returns (i.e. a greater chance of outperforming at any time) and the size of the outperformance was between 3-5 funds a sector.

How do you pick the trail blazing fund managers to follow?

One way would be to do a similar correlation analysis as I've just done and then wittle down the funds to a potential shortlist before looking at how each manager is trying to invest their money. That would take days to do.

But there is an easy way. Take a look at those funds sitting at the top of the performance table (table 2) and coloured green. You will notice that they are the very funds that have regularly been highlighted by the 80-20 Investor algorithm in recent months for the UK All Companies sector. In fact a number of them appear in the current Best of the Best Selection.

In short the 80-20 Investor algorithm highlights funds that are working in the current environment and have a good chance of maintaining that momentum. That is those fund managers that have not only backed their convictions but whose convictions are correct.

Similarly if Tom Dobell's fortunes do turn around and his investment style starts to be rewarded our algorithm will highlight his fund long before everyone else starts backing him. You can then enjoy the ride upwards as remember every dog (and fund manager) has its day.

Table 1 - Following the herd

Funds coloured red are those following the heard. Orange funds are still heavily influenced by the herd while the funds in green are attempting to break rank.

Fund Name	UK All Companies
AXA     Framlington UK Growth R	0.99
F&C     Responsible UK Equity Growth 1	0.99
L&G     Ethical I	0.99
Royal London   UK Equity A	0.99
Schroder     MM UK Growth A	0.99
Schroder     UK Alpha Plus A	0.99
Scot Mut     UK Equity	0.99
Scottish Widows   Multi-Manager UK Equity Focus A	0.99
Scottish Widows   Multi-Manager UK Equity Growth A	0.99
Threadneedle   UK Institutional	0.99
Threadneedle   UK   Inc	0.99
Aberdeen     Foundation Growth A	0.98
Aviva Inv   UK Equity A	0.98
BlackRock   350 UK Equity Tracker A	0.98
BlackRock   UK Equity Tracker A	0.98
BlackRock Invest Mgrs UK Ltd   Charishare Common Invest Gr	0.98
CAF     UK Equitrack	0.98
F&C     FTSE All Share Tracker 1	0.98
Fidelity     Index UK P	0.98
Halifax     UK FTSE All Share Index Tracker C	0.98
Henderson   UK Index A	0.98
HSBC     FTSE All Share Index C	0.98
Investec     UK Alpha A	0.98
JPM     UK Strategic Equity Income A	0.98
L&G     (A&L) Capital Growth	0.98
L&G     (N) Tracker Trust A	0.98
L&G     UK Index R	0.98
L&G     UK Select Equity A	0.98
Old Mutual   UK Alpha A	0.98
Old Mutual   UK Equity A	0.98
Old Mutual   UK Index A	0.98
Royal Bank of Scot   Growth	0.98
Royal London   UK FTSE4Good Tracker Trust	0.98
Santander   Premium UK Equity A	0.98
Schroder     UK Equity A	0.98
Threadneedle   UK Overseas Earnings Z Inc	0.98
Aberdeen     UK Enhanced Equity A	0.97
Aviva Inv   UK Growth A	0.97
Aviva Inv   UK Opportunities 1	0.97
AXA     General Trust R	0.97
BlackRock   100 UK Equity Tracker A	0.97
BlackRock   UK Special Situations A	0.97
Fidelity     UK Select	0.97
Halifax     Special Situations C	0.97
Halifax     UK Growth C	0.97
Henderson   UK Alpha A	0.97
HSBC     FTSE 100 Index C	0.97
L&G     UK 100 Index R	0.97
Liontrust   Special Situations R	0.97
Royal London   UK Growth Trust	0.97
Santander   Stockmarket 100 Tracker Growth RA	0.97
Schroder     The Growth Trust For Charities	0.97
Scottish Widows HIFML   Special Situations 1	0.97
Scottish Widows HIFML   UK Growth 1	0.97
SJP     UK Growth	0.97
Aberdeen     UK Equity A	0.96
Barclays     UK Core A	0.96
Halifax     UK FTSE 100 Index Tracking C	0.96
HSBC     UK Focus A Inst	0.96
HSBC     UK Growth & Income B	0.96
JOHCM     UK Dynamic B	0.96
Jupiter     Growth & Income	0.96
Kames     UK Equity A	0.96
Liontrust   UK Growth R	0.96
Majedie     UK Equity A	0.96
NFU Mutual   UK Growth A	0.96
Royal London   UK Opportunities A	0.96
Schroder     Core UK Equity A	0.96
Schroder     UK Opportunities A	0.96
SJP     UK & General Progressive	0.96
SVM     UK Growth A	0.96
Threadneedle   UK Growth & Income	0.96
Aviva Inv   UK Index Tracking 1	0.95
CF Canlife   UK Equity B	0.95
EdenTree     UK Equity Growth A	0.95
FP     Russell UK Growth Assets C	0.95
Franklin     UK Managers' Focus A	0.95
Henderson   UK Equity Income & Growth A	0.95
Investec     UK Special Situations A	0.95
JPM     UK Dynamic A	0.95
JPM     UK Managed Equity A	0.95
Kames     Ethical Equity A	0.95
M&G     Index Tracker A	0.95
Old Mutual   Equity 2 A	0.95
Premier     Ethical A	0.95
Royal London   UK Growth A	0.95
Santander   UK Growth RA	0.95
SSgA     UK Equity Tracker	0.95
Threadneedle   UK Select	0.95
Vanguard     FTSE U.K. All Share Index A	0.95
AXA     Framlington UK Select Opportunities R	0.94
BlackRock   UK A	0.94
EdenTree     Amity UK A	0.94
Family     Charities Ethical	0.94
FP     CAF UK Equity A	0.94
Henderson   Global Care UK Income A	0.94
JOHCM     UK Opportunities B	0.94
Jupiter     UK Special Situations	0.94
Premier     UK Growth A	0.94
R&M     UK Equity High Alpha A	0.94
Scottish Widows   UK Growth A	0.94
Standard Life Investments   UK Equity Growth	0.94
Virgin     UK Index Tracking	0.94
Artemis     Capital R	0.93
Artemis     UK Growth R	0.93
Invesco Perpetual   UK Strategic Income	0.93
JPM     UK Strategic Growth A	0.93
L&G     Growth E	0.93
Marks & Spencer   UK Select Portfolio	0.93
Schroder     Charity Equity A	0.93
Schroder     Income A	0.93
Scottish Widows   UK Tracker G	0.93
SJP     UK High Income	0.93
Standard Life Investments   Ignis Balanced Growth A	0.93
Barclays     UK Alpha A	0.92
BlackRock   Mid Cap UK Equity Tracker A	0.92
Fidelity     UK Growth	0.92
HSBC     FTSE 250 Index C	0.92
Invesco Perpetual   Childrens	0.92
Invesco Perpetual   Income & Growth	0.92
Invesco Perpetual   UK Growth	0.92
Majedie     UK Focus A	0.92
Marks & Spencer   UK 100 Companies	0.92
Alliance Trust   Sustainable Future UK Growth 1	0.91
Fidelity     Moneybuilder Growth	0.91
Invesco Perpetual   High Income	0.91
Invesco Perpetual   Income	0.91
Man GLG     Undervalued Assets Professional C	0.91
R&M     UK Equity Long Term Recovery A	0.91
Alliance Trust   UK Ethical A	0.9
BlackRock   UK Focus FF	0.9
M&G     UK Growth A	0.9
Old Mutual   UK Mid Cap A	0.9
Royal London   UK Mid-Cap Growth A	0.9
SVM     UK Opportunities A	0.9
Architas MM   UK Equity A	0.89
Old Mutual   Equity 1 A	0.89
Standard Life Investments   UK Ethical	0.89
AXA     Framlington UK Mid Cap R	0.88
Baillie Gifford   UK Equity Alpha A	0.88
Fidelity     Special Situations A	0.88
GAM     UK Diversified	0.88
Invesco Perpetual   UK Aggressive	0.88
Newton     UK Equity	0.88
Artemis     UK Special Situations R	0.87
L&G     UK Special Situations I	0.87
Newton     UK Opportunities	0.87
Standard Life Investments   UK Equity Unconstrained	0.86
Standard Life Investments   UK Opportunities	0.86
M&G     Recovery A	0.85
Jupiter     UK Growth	0.84
Franklin     UK Mid Cap W	0.83
Man GLG     UK Select A ail	0.82
Schroder     Recovery A	0.82
SJP     Equity Income	0.81
Threadneedle   UK Mid 250	0.8
Royal London   Sustainable Leaders Trust C	0.79
MFM     Slater Growth	0.75
Cavendish   Opportunities A	0.73
Neptune     UK Mid Cap A	0.7
CF     Miton UK Value Opportunities A	0.69
L&G     UK Alpha I	0.69
Schroder     UK Mid 250 A	0.68

 

Table 2 - It pays to be different

Fund Name	1 year return %
Old Mutual   Equity 1 A	31.77
Old Mutual   UK Mid Cap A	30.19
CF     Miton UK Value Opportunities A	24.49
Threadneedle   UK Mid 250	22.62
Neptune     UK Mid Cap A	22.03
Franklin     UK Mid Cap W	21.72
Standard Life Investments   UK Opportunities	19.74
AXA     Framlington UK Mid Cap R	19.4
Franklin     UK Managers' Focus A	19.18
Royal London   UK Mid-Cap Growth A	18.97
Standard Life Investments   UK Ethical	18.58
MFM     Slater Growth	18.32
SVM     UK Growth A	17.98
Alliance Trust   UK Ethical A	17.19
Jupiter     UK Growth	16.54
Alliance Trust   Sustainable Future UK Growth 1	16.53
EdenTree     UK Equity Growth A	16.21
Newton     UK Equity	16.09
Premier     Ethical A	16.06
Newton     UK Opportunities	15.96
Henderson   Global Care UK Income A	15.69
Fidelity     UK Select	15.55
Kames     Ethical Equity A	15.36
Royal London   Sustainable Leaders Trust C	15.18
HSBC     FTSE 250 Index C	14.44
Standard Life Investments   UK Equity Unconstrained	14.36
Fidelity     Moneybuilder Growth	14.23
BlackRock   Mid Cap UK Equity Tracker A	14.21
L&G     UK Special Situations I	14.04
L&G     Ethical I	13.91
JPM     UK Dynamic A	13.9
Invesco Perpetual   UK Strategic Income	13.61
Invesco Perpetual   High Income	13.49
EdenTree     Amity UK A	13.24
Artemis     UK Growth R	13.2
Invesco Perpetual   Income	12.98
Fidelity     Special Situations A	12.95
Henderson   UK Alpha A	12.79
Majedie     UK Focus A	12.75
Threadneedle   UK Select	12.04
SVM     UK Opportunities A	11.86
Schroder     UK Mid 250 A	11.57
BlackRock   UK Focus FF	11.52
JPM     UK Strategic Growth A	11.03
Standard Life Investments   Ignis Balanced Growth A	11.01
Premier     UK Growth A	10.8
Kames     UK Equity A	10.76
Man GLG     Undervalued Assets Professional C	10.48
Cavendish   Opportunities A	10.46
SJP     UK High Income	10.1
CF Canlife   UK Equity B	10
F&C     Responsible UK Equity Growth 1	9.93
Royal Bank of Scot   Growth	9.63
Artemis     Capital R	9.22
BlackRock   UK A	9.21
L&G     Growth E	9.13
Threadneedle   UK Growth & Income	9.09
Aviva Inv   UK Equity A	9.05
Invesco Perpetual   Income & Growth	8.96
Fidelity     UK Growth	8.76
Aviva Inv   UK Opportunities 1	8.63
Investec     UK Alpha A	8.44
Threadneedle   UK   Inc	8.11
HSBC     UK Growth & Income B	8.05
Royal London   UK Growth Trust	7.96
Threadneedle   UK Overseas Earnings Z Inc	7.88
FP     CAF UK Equity A	7.78
BlackRock Invest Mgrs UK Ltd   Charishare Common Invest Gr	7.74
Liontrust   Special Situations R	7.61
BlackRock   UK Special Situations A	7.54
HSBC     UK Focus A Inst	7.41
JOHCM     UK Opportunities B	7.23
Royal London   UK Opportunities A	7.08
Man GLG     UK Select A ail	7.01
SJP     UK & General Progressive	6.86
Liontrust   UK Growth R	6.82
UK All Companies ail	6.82
Scottish Widows   Multi-Manager UK Equity Focus A	6.68
JPM     UK Strategic Equity Income A	6.61
Scot Mut     UK Equity	6.61
Schroder     UK Equity A	6.59
Architas MM   UK Equity A	6.55
Barclays     UK Alpha A	6.5
Aviva Inv   UK Growth A	6.47
Majedie     UK Equity A	6.45
AXA     Framlington UK Select Opportunities R	6.18
Baillie Gifford   UK Equity Alpha A	6.15
Standard Life Investments   UK Equity Growth	6.13
Invesco Perpetual   Childrens	6.12
Jupiter     Growth & Income	5.96
AXA     Framlington UK Growth R	5.8
Schroder     Income A	5.69
Invesco Perpetual   UK Growth	5.65
JOHCM     UK Dynamic B	5.59
Threadneedle   UK Institutional	5.58
AXA     General Trust R	5.51
FP     Russell UK Growth Assets C	5.39
Santander   Premium UK Equity A	5.38
Schroder     Charity Equity A	5.38
M&G     UK Growth A	5.35
SJP     UK Growth	5.35
Scottish Widows   Multi-Manager UK Equity Growth A	4.82
Henderson   UK Equity Income & Growth A	4.78
Jupiter     UK Special Situations	4.63
R&M     UK Equity High Alpha A	4.54
GAM     UK Diversified	4.52
Old Mutual   UK Equity A	4.22
Royal London   UK Equity A	4.21
L&G     UK Select Equity A	4.15
Marks & Spencer   UK Select Portfolio	4.14
Artemis     UK Special Situations R	4
SJP     Equity Income	3.94
Schroder     UK Alpha Plus A	3.65
Old Mutual   Equity 2 A	3.62
Schroder     MM UK Growth A	3.4
Santander   UK Growth RA	3.19
Old Mutual   UK Index A	3.14
BlackRock   350 UK Equity Tracker A	3.06
SSgA     UK Equity Tracker	3.02
HSBC     FTSE All Share Index C	2.96
Investec     UK Special Situations A	2.81
Vanguard     FTSE U.K. All Share Index A	2.79
Fidelity     Index UK P	2.78
JPM     UK Managed Equity A	2.77
Royal London   UK FTSE4Good Tracker Trust	2.77
CAF     UK Equitrack	2.68
M&G     Index Tracker A	2.65
L&G     UK Index R	2.63
F&C     FTSE All Share Tracker 1	2.6
BlackRock   UK Equity Tracker A	2.59
Old Mutual   UK Alpha A	2.53
Scottish Widows HIFML   UK Growth 1	2.36
Barclays     UK Core A	2.31
Henderson   UK Index A	2.31
Scottish Widows   UK Growth A	2.29
Royal London   UK Growth A	2.2
Invesco Perpetual   UK Aggressive	2.04
Halifax     UK FTSE All Share Index Tracker C	2.02
Aviva Inv   UK Index Tracking 1	1.95
Halifax     UK Growth C	1.91
L&G     (N) Tracker Trust A	1.91
Aberdeen     Foundation Growth A	1.85
L&G     (A&L) Capital Growth	1.5
Schroder     Recovery A	1.11
Virgin     UK Index Tracking	1.11
Marks & Spencer   UK 100 Companies	1.02
Schroder     UK Opportunities A	0.86
NFU Mutual   UK Growth A	0.85
Scottish Widows   UK Tracker G	0.66
R&M     UK Equity Long Term Recovery A	0.57
L&G     UK 100 Index R	0.53
HSBC     FTSE 100 Index C	0.44
Aberdeen     UK Enhanced Equity A	0.43
Santander   Stockmarket 100 Tracker Growth RA	0.29
BlackRock   100 UK Equity Tracker A	0.16
Family     Charities Ethical	-0.11
Halifax     UK FTSE 100 Index Tracking C	-0.31
Aberdeen     UK Equity A	-0.73
L&G     UK Alpha I	-1.08
Schroder     The Growth Trust For Charities	-2.24
Scottish Widows HIFML   Special Situations 1	-2.57
Halifax     Special Situations C	-2.58
M&G     Recovery A	-4.39
Schroder     Core UK Equity A	-4.98

 

 

(image by dan via freedigitalphotos.net)

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