What are the benefits of manager diversification in an extremely concentrated Australian equity market?
Diversification of manager (or blending as it is also known) is understood to provide many investor benefits. However, we believe that blending can actually remove the majority of any active risk from an alpha-generating manager (that seeks to actively pick stocks to outperform an index). This results in diluted investor returns to a point that they end up with benchmark returns. Passive investing will give you a similar outcome at a much lower cost.
The following chart shows the average weights in the ASX 200 Index top 10 stocks by the five largest managers in our market, compared to the ASX 200 itself. The average weights show that the level of active bets compared to the Index is low. Why then do investors continue to support them, and what is the point in blending them?
Source: Allan Gray / Morningstar / van Eyk
Investor outcomes are impacted by intermediation. Research, dealer group approved lists, model portfolios and concerns about ‘manager risk’ all play a part. Perhaps fund managers also contribute to this outcome by being happy to receive a 3-5% slice of portfolios to achieve their numbers, targets and bonuses.
We believe that many managers’ insipid approach to active management contributes to the increased interest in direct equities. Investors’ desire to trade stocks with little expertise is at odds with logic but the perceived benefits versus managed funds is alluring.
The term blue-chip is loosely used as a safe haven for investment. Memories of Babcock & Brown and ABC Learning fade from memory, but the risks of permanent loss of capital are significant, even in the top 20 stocks. Even if an investment does not go to zero, you can still lose – as those that bought Qantas for $5.30 in August 1999 will know.
The real irony with direct equities is that often a portfolio of 10-15 stocks, put together with little regard for capital risk, is considered adequate. But where investors use managed funds it is not uncommon to blend many managers, each holding 30-60 stocks, with a lot of duplication in holdings.
If you believe in active management, dig deeper to understand managers more. Then invest with greater conviction. Pursue active management in a way that disregards what blending and model portfolios worry about most – the risk of being different. Consider the following to help stack the odds in investors’ favour.
- Is private ownership of the fund manager better than public ownership?
- Is the manager aligned with my client’s best interests?
- Is the fee structure reasonable?
- How does the manager manage their own money?
- Is the anomaly the manager is trying to exploit enduring?
- Is the manager attempting to just gather assets off the back of a short term trend/fad?
- Is the performance track record relevant?
- Has the manager proven to be skilful or has luck played a bigger part?
