When diversification drags returns

Ask most investment professionals to define diversification, and they’ll probably tell you it’s a way to reduce volatility and risk. But in an era of high volatility, it can be hard to figure how much stock diversification is necessary—especially as more index products flood the market. How much is too much?

When active becomes passive

A key sign of overdiversification is a stock portfolio that performs like a broad equity index, says Bryce Matlashewski, an advisor at National Bank Financial in Winnipeg. “You might not lose money in your portfolio, but you might not gain, either,” at least relative to the index. Given that reality, why would clients want to pay a manager to manage thousands of stocks—a task Matlashewski says is virtually impossible to undertake effectively?

But Nancy Graham, portfolio manager, PWL Capital Inc. in Ottawa, says owning the broad index is the end goal. “It’s hard for managers to beat the index, particularly after fees,” she explains, referring to studies like the 2015 Mid-Year SPIVA study, which showed only 23% of Canadian equity funds outperformed the S&P/TSX composite over five years.

“How do you overdiversify if you buy the market?” she asks. “We‘ve seen people hold nine or 10 Canadian mutual funds in the same portfolio, all holding the same securities,” she explains. In that case, she would sell them all and buy an ETF with exposure to a broad global index to achieve better diversification.

“There are so many ETFs that can do everything you need and at such a low cost,” agrees Eric Kirzner, the John H. Watson Chair in Value Investing at the Rotman School of Management in Toronto. But, there’s an argument for active when “you have a skilled research team providing you with securities you really think will outperform.”

95%

The diversification opportunity that a portfolio of 22 to 45 stocks generally captures.

Assume you do. What’s the right number of stocks to own? The optimal diversification level has been a moving target, says Kirzner. “Back in the 1960s, the notion was that it took 15 U.S. and 30 Canadian stocks to achieve a diversified portfolio,” he explains, adding that individual investors today need no more than 40 to 50 names. “But the literature is all over the place on that; there is no magic number,” he says.

“There are no hard and fast rules,” agrees Adam Butler, CEO, ReSolve Asset Management in Toronto. “A portfolio of 22 to 45 stocks generally captures about 95% of the diversification opportunity.”

How to mix and match managers

While owning 10 Canadian equity mutual funds is excessive, there are cases where you can mix and match managers focused in the same areas, says Neil Simons, a managing director at Northwater Capital in Toronto. “If you’re looking at a handful of generic Canadian managers all doing the same thing, then yes, that’s too many,” he says. “But if they are specialized in different market segments, such as small cap, technology or energy, then you might have additional diversification.”

To determine whether an equity manager is adding value, the institutional investors Simons works with analyze the tracking error of each one against the broad index. Then, they use a factor-regression model to determine how closely managers are correlated historically. “You’re going to find some managers are very different—which is good. But you might also find some are very similar, and you don’t need all of them.”

Aside from sophisticated modeling tools, advisors can follow a few rules when it comes to mixing and matching stock factors like size, value and momentum.

The point of looking at equity style factors is to figure out how stocks behave in different market environments. The trick is to understand which factors work together to add diversification—and which ones cancel each other out. For example, Butler says, “A value portfolio is typically composed of securities that have dropped in price over the last several years, and that are cheap on a variety of fundamental metrics such as price-to-book and price-to-cash flow.” On the other hand, “momentum portfolios hold stocks whose prices have moved up the most over the last six- to 12-month period.”

Hence, combining value and momentum stocks can add another level of diversification: “The correlation between them is very low because they operate on different principles,” he says. “If you take the top 10% of stocks by value and the top 10% of momentum stocks, you will have two very different portfolios with little overlap,” he explains.

And there are other styles that are inherently diversified. For Kirzner, value and growth can each deliver different portfolios. “If you accept the 3% value premium over growth for the long term,” Kirzner explains, the two make sense together—with a caveat. “Make sure you’re not sitting with 200 names in two funds that look similar. A good advisor will look at the top 10 holdings of any given manager and make sure there is not a lot of duplication.”

Butler says that’s tricky to do with ETFs: if you buy a value ETF and a growth ETF, the growth ETF will simply contain all the stocks that aren’t value stocks. “You’ve basically just bought the index.”

However, a style combination that could work in an index context is size: “Research shows small-cap stocks outperform large caps over the long term,” Butler explains, adding there’s an easy way to do it. “If you buy a dividend index of 30 big large-cap stocks, you will simply track the TSX. But if you bought the 1000 top stocks by market capitalization, you have exposure to the biggest and smallest stocks in the index, which might give you an edge.”

30

If you buy this number of large-cap stocks, it’s likely that you will simply track the TSX.

But while specific styles and factors go well together, there comes a point of diminishing returns, says Simons. And it’s not just because fees start to add up—an overstretched advisor can be just as problematic if he doesn’t have time to do the requisite due diligence on a long list of funds. “There are costs associated with selecting and interviewing managers,” he says.

And while he works mainly in the institutional space, the time spent managing managers means you’re not out spending it with clients. “That can be seen as a cost.”

Caught in the weeds

For Simons, diversification needs to be about the client’s end goal, and that comes down to the overall portfolio asset mix. Getting stuck on specific securities in the portfolio can lead an investor into the weeds—even large pension investors, he notes, can get caught up in making incremental decisions. They may, for instance, question whether or not to add North American mid-caps to an internationally diversified equity portfolio. “It will not improve their risk-adjusted returns. It will just shift things around slightly.”

And advisors must look at how a basket of stocks interacts with the rest of the portfolio, using client goals to drive how much you focus on each piece. “A lot of people will spend too much time on the equity portfolio, which is the largest risk contributor, but they may not have a lot of diversification happening in other asset classes,” says Simons.

Ensure the overall asset mix of stocks and bonds is in line with a client’s goals and risk tolerance.

Butler agrees. “Diversification should be about mixing both stocks and bonds; you’re going to get, by orders of magnitude, more diversification by adding government bonds. If you add one government bond to the portfolio, you’ll get way more diversification than by adding 1,000 stocks.”

Indeed, the ultimate sign of a well-diversified portfolio is in the overall performance of all asset classes and securities together. If that’s in line with what the investor needs, then it’s working fine.

by Caroline Cakebread, a Toronto-based financial writer