Diversification is like mothers’ milk in the financial advice industry. If you had to nominate one portfolio strategy that every adviser can agree on, it’s probably that spreading your risks is a good thing.
The problem is making sure that it works efficiently in practice.
The first thing to note is that spreading your money with a range of fund managers is not diversification; it’s just spreading your money with a range of fund managers. Let’s say you wanted to invest in a portfolio of Australian shares. You receive a Statement of Advice recommending that you invest in four funds: the ABC Gold Fund, the XYZ Bullion Fund, the Acme Precious Metals Fund and the Eldorado Yellow Metal Trust. Is that a diversified share portfolio? In terms of the gold sector, maybe yes, but obviously you wouldn’t have any exposure to the other 96% of the local stock market.
What if the Statement of Advice recommended eight different funds that covered nearly every sector of the stock market. For example, funds that specialise in growth stocks, value stocks, industrials, resources, gold, large caps, mid-caps and small companies. Surely you couldn’t get more diversified than that?
That’s probably true and it’s quite common to see real-world financial plans with exactly this kind of recommended portfolio. But what has been achieved by covering every market segment with eight different fund managers?
Let’s start with the growth and value stock funds. History and logic suggest that these funds are very unlikely to do well at the same time because they’re like opposite poles on a magnet. The same is true for industrials and resources, and to a lesser extent large cap and small cap stocks.
All the planner has done here is create a portfolio which will almost guarantee you a return that’s close to the market index. And if that’s the case, why are you paying 2% a year in active management fees? You might as well invest in an index fund for less than half the price.
The combination of diversification and active funds management can end up a bit like an expensive, non-alcoholic cocktail. There’s no point diversifying so much that all the active managers cancel each other out.
In our view, index funds and enhanced index funds should be the default option for many investors. They are transparent, effective and generally represent good value for money.