Beware of Diworsification

When making investment decisions we’ve all heard the time-tested analogy ‘don’t put all your eggs in one basket’. While it cannot guarantee against losses, diversifying your portfolio effectively to help you navigate the volatility of markets is vital to achieving your long-term financial goals.

One way to achieve this is by using different asset classes to diversify your investment portfolio. This is because not all asset classes are affected in the same way by different events. Those that perform differently from one another can be referred to as uncorrelated asset classes. Typically, bonds and equities have been found to be uncorrelated, so when one underperforms, the other tends to outperform, providing protection against a major loss.

However, you can also diversify your investment within an asset class itself to further mitigate risk. For example, if choosing to invest in equities, you could choose both large and small companies, those in different sectors and those in different geographical locations. You can even choose to be in an investment structure that can be long and short equities. Being long equities does well when their price goes up and being short equities does well when their price goes down.

It's been said that diversification is the investing equivalent of a free lunch, but is it possible to overdiversify – or 'diworsify'? The term diworsification was coined by Peter Lynch in his book, “One Up on Wall Street”, where he used the term to explain that some companies expand into areas that are so widely different from their core business, that it ultimately serves to their detriment. Although he used the term to describe a company specific problem, diworsification has evolved into a concept that describes the issue of adding too many asset classes with similar correlations to a portfolio, thereby negatively impacting both the risk and performance.

Source: MoneyMate, as at 28 February 2022. The Equity Market is measured as the FTSE All Share Total Return Index. Largest equity funds represent the top 5 largest equity funds in the ASISA Equity General category. The investment performance is for illustrative purposes only.

Overdiversification can also mean owning shares in overlapping unit trust funds - the graph above illustrates this concept. We compared a portfolio of 20% in each of the 5 largest equity funds against the FTSE/JSE All Share Index TR (ALSI) over a 3 year period. In essence, when the graph is above zero it indicates that the portfolio has outperformed the market (measured by the ALSI), and equally, when the graph is below zero it reflects underperformance. As is evident from the light blue line on the graph, a portfolio invested in the 5 largest equity funds would have experienced steady underperformance versus the market over time. When you diversify across too many asset managers or funds that are too closely correlated, your underlying portfolio starts looking a lot like the index. This stands in stark contrast to the 36ONE BCI Equity Fund which is illustrated by the red line. This fund has significantly outperformed the South African equity market over time net of fees. The table above shows that over a 3 year period, which has been a particularly volatile time for equity markets, the 36ONE BCI Equity Fund has outperformed the average of the 5 largest equity funds by 7.8% per year.

This graph highlights the importance of focusing on the right funds in the right proportions. To avoid selecting funds that overlap, it’s important to analyse the composition of the funds. Another key point to note when selecting funds in the same category is that funds may have different investment styles based on differing investment philosophies. Value managers, for example, choose shares that offer very good value for their price. Other styles are growth, momentum and quality. At 36ONE, we believe that our investment approach is one of the key factors that sets us apart. We are style agnostic, meaning we combine our best ideas irrespective of past market definitions (i.e. growth, value or quality) and aim to achieve high returns with less risk. This flexible approach means our portfolios are well diversified and allows investors to gain throughout economic cycles in which the general market favours either growth, value or quality investment styles. Another important aspect of our approach is that we are nimble. Our assets under management are small in comparison to the traditional South African asset managers. Our size enables us to implement a wider range of ideas, with faster execution. This has been a key advantage for us, particularly over the last few years where stock markets have been extremely volatile. As is evident from the above graph, our approach has been a key contributor to delivering significant outperformance for clients.

Alternatives such as long/short hedge funds offer uncorrelated returns which can help to mitigate against large drawdowns in equity markets. The 36ONE hedge fund has a 16 year proven track record of substantially outperforming equities with much lower volatility and delivering extremely rewarding net of fee returns to our investors. Including the 36ONE hedge funds in your investment portfolio can provide better protection on the downside, while capturing performance on the upside.

Asset allocation should be based on a client’s situation, his/her needs today and in the future, and his/her ability to stay the course during adverse market conditions. At the same time, it’s important to note that asset allocation should not be static, but rather fluid - it needs to change over time as you age, your financial situation changes, and your goals evolve.