Day: 10 August 2020

An article written by Ray Calleja: Head – Private Clients, MeDirect

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In previous articles, we discussed the importance of diversification in an investment portfolio, where you invest in securities that perform differently in a specific situation. It can help reduce volatility and potentially increase your returns over time. Today, we will discuss the problem where you could be investing in several mutual funds with overlapping positions, which can actually reduce the effectiveness of diversification.

A frequent investing theme of today is owning more than a dozen mutual funds. Often purchased over time with little thought as to how the collection fits together, if at all. Owning several funds can result in creating significant overlap of securities. That is, individual holdings within the mutual funds are often the same, or quite similar. While fund names differ, their holdings may not.

This can happen because different funds may highlight the same or similar parts of the market and result in a portfolio concentrated in one particular equity, industry, economic sector or geographic region. This can help dilute your effort of diversification. However, checking your portfolio for fund overlap is relatively easy.

Fund overlap will expose you to the risk of having too much money concentrated in one or a limited number of securities. This can lead to below-average returns and possibly higher volatility and ultimately it can mean that you will not achieve your financial goals. Many experts recommend that you should review your portfolio at least once a year to check for overlap and take the necessary steps to correct it. Admittedly, diversification cannot guarantee a profit or protect you against loss in down markets but it usually comes close to doing so.

Overlap in your portfolio can happen in many ways and it is not always so apparent. Let us say you own two funds which have clearly distinct and different investment strategies, say a value fund and a growth fund. The manager of the growth fund might emphasize a particular consumer staples equity because of the company’s position in a rapidly expanding market, while the manager of a value fund might like the same company’s financial fundamentals, e.g. free flowing cash flow. You may also cause overlap in your investment portfolio if you are easily influenced by big headlines in market news and you stray from your intended strategy by investing in single equities or funds that invest in specific economic sectors or industries. But in reality, if you already own a diversified portfolio, you are likely to be already exposed in these sectors.

The value of gold has shot up very significantly in the last few weeks and months. So, you think of buying an ETF (exchange-traded-fund) that attempts to reflect the performance of the price of gold bullion. However, your existing equity funds may already own shares of many gold-related stocks, so your new investment may render you excessively exposed to any meaningful changes in gold prices.

By buying a sector fund you may be exposing yourself to an overall concentrated exposure to a niche of the market, potentially hindering long-term returns.

How to maintain diversification

First start by examining your portfolio and examine your asset allocation. Is your balance of equities, bonds, and short-term investments (such as cash and bank accounts) right in terms of your investment goals and time horizon? Next, evaluate diversification within each asset class.

One method would be to estimate the amount of overlap you may have in individual assets and specific market sectors by comparing the top holdings of all your funds. You can easily find the top holdings in your funds’ annual or semi-annual reports; most fund fact sheets also include this information (regularly updated and provided on the MeDirect website).

The Morningstar Style Box can also be extremely useful when it comes to making sure that your portfolio is still diversified. Based on a fund’s most recent portfolio fact sheet the style box will tell you where the fund manager has gone with his/her strategy. Has he stuck to the original plan or has he deviated from it over time? By using the Style Box, you should aim to cover the four corners of the box. After all, value funds do not act much like growth portfolios, and small-cap funds behave differently from large-cap offerings. So, if you are too heavy in large value, try to increase your exposure in large-growth, small-value, or small-growth funds. We do tend to overdo investments in the large-cap global companies. They are constantly in the news and are easy to buy. So, once you have selected a large-value and a large-growth fund, your next step is to start looking at options elsewhere in the style box.

In previous articles, we also discussed the statistical measure called R² (R-squared), which tells you about a particular investment’s correlation or its similarity to a given benchmark. An R-squared of 100 indicates that all movements of a fund can be explained by movements in the index. Therefore, if you already have, say an S&P 500 Index Fund, you want to make sure that other funds, which you own in your portfolio do not have an R-squared that is too close to 100. This would indicate a level of fund overlap that causes both funds to perform very similarly. Remember, you want proper diversification to minimize market risk.

Another common occurrence for the potential for fund overlap exists when you own more than one fund managed by the same fund manager. No matter how outstanding and excellent the person or team has been, mutual fund managers have particular philosophies and styles that they rarely deviate from, irrespective of the fund they run. Just like you have your own way of going about your work, fund managers have theirs. If he/she is bullish on a particular stock or sector, he might ensure that that stock or sector is a part of all the funds he/she manages. So, when that stock/sector goes down, your entire return will get hit and so does the value of your portfolio.

Even if the funds in your portfolio had low levels of overlap when you first purchased them, it doesn’t mean their respective styles won’t drift towards each other. This is called style drift and it is not uncommon. For example, a mid-cap stock fund could slowly drift toward a large-cap categorization as the fund manager progressively buys stocks of larger companies, hence that is why it is recommended that you review your fund portfolio at least annually.

In terms of your equity allocation you will need to assess your holdings in U.S. / European large-cap stocks, a small allocation to mid- and small-cap U.S. / European stocks  and possibly another small allocation to emerging market stocks. You should also look at your portfolio’s exposure to growth and value – ideally you should have a similar allocation to each investment style. Your portfolio should also reflect a similar picture in terms of weight to the economic sectors, which are found in the broad market. Your stakes in individual companies should not exceed 5% to 10% of your overall investment portfolio. In the case of bonds, investors should see that their main allocation is in investment-grade corporate bonds and government bonds or Treasuries, with only a small allocation in high-yield and other non-investment grade bonds.

If you find out that your mutual funds have significant overlapping positions, you need to take corrective action right away. You need to bring your portfolio back to your target allocation by selling those funds with the redundant and overloaded asset (and sub-asset) classes and using the sale proceeds to purchase shares of areas, where your portfolio has insufficient representation. Deciding which fund to sell can be challenging, but it may help to consider which one has performed better and which one is more expensive. Or, make it easy on yourself and consult a financial advisor (you can contact one at MeDirect by emailing wealthsupport@medirect.com.mt and ask for an appointment).

The importance of regularly examining your portfolio cannot be over-stated. You will thus be able to maintain exposure to a wide variety of assets which will help you weather market turbulences that occur from time to time. Like that you will stay on top of fund overlap as you adhere to your long-term investment objectives.

Be mindful in the future

Going forward  and having your attention drawn to avoid fund overlap, you should, in future, avoid investing in funds with positions that overlap significantly. Before buying a new fund have a close look at the fund holdings to avoid common exposures to your portfolio, hence rendering investment in such exposures redundant.

Limiting overlap is one of the most important steps you can take to reduce risk in your portfolio. Still, you probably will not be able to avoid overlap altogether, as many funds invest in the same companies. Your goal should be to minimise overlap, not totally eliminate it.

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The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties.

MeDirect Bank (Malta) plc, company registration number C34125, is licensed by the Malta Financial Services Authority under the Banking Act (Cap. 371) and the Investment Services Act (Cap. 370).

The financial instruments discussed may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in any of the products discussed you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

The world is waking up the 4th Industrial Revolution, with the impact of COVID-19 accelerating many changes already underway, says Franklin Templeton’s Head of Equities, Stephen Dover. He opines on how underlying fundamental disruptions in our economy can present opportunities for active investors.

Remember the story of lazy Rip Van Winkle who slept for 20 years, missed the American Revolution, and awakened to a new country? Similarly, the world is waking up to the 4th Industrial Revolution, a time of massive change led by innovation, which the impact of the COVID-19 virus has accelerated. This year will be remembered as a tragic one, with much suffering and many lives lost, and also as a fulcrum for health, economic and social disruptions.

• Trends that might have happened over the next decade or so are accelerated into 2020. Tele-health, remote learning, working from home, internet retail, and many technological innovations are changing commerce and our ways of living and interacting. We are not going back to “the way it was” pre-COVID-19, especially now that it seems the pandemic will be with us for many more months.
• Why are the US equity markets near all-time highs? One reason is because massive fiscal and monetary stimuli have put a backstop against corporate and personal insolvency. The downside risk has been reduced. Normally when you have a recession, the US equity markets drop on average around 40%.1
• Due to tremendous social and economic changes, several notable companies are facing bankruptcy. Many of these “old economy” companies are closing more so because they are being disrupted by innovation, e.g., the “old” retail companies, than because of the economic slowdown. Their demise is primarily related to the acceleration of trends—changes in the way our economy and lives are structured.
• There are some companies that will not make it through this upheaval and there are others that will forge a new paradigm. We should invest in companies that are innovators in their industries, and equally important, we need to avoid companies that will be disrupted. It could be as important to avoid bad companies as it is to find good companies.
• Investors might look back on this time as a break from reversion-to-the-mean investing.

Over the next few months, it’s likely headlines will be filled with news on vaccine trials, political uncertainty, a deepening recession and more social unrest. But underlying this are fundamental disruptions in our economy that will impact how we live and work—this also presents opportunities for active investors who are observing the longer-term trends.

Franklin Templeton Key risks & Disclaimers:

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What are the risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For stocks paying dividends, dividends are not guaranteed, and can increase, decrease or be totally eliminated without notice. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.

MeDirect Disclaimers:

This information has been accurately reproduced, as received from Franklin Templeton Investment Management Limited (FTIML). No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

Olly Russ, fund manager at Liontrust, shares his views in a short article below.

 

Following the Revolutionary War, the lawyer, scholar and soldier Alexander Hamilton was appointed the first Treasury Secretary of the newly-formed United States. A busy man, he also found time to start the New York Post, the US Coast Guard and the Bank of New York, as well as establish the centralised US Mint and the prototype central banks: Bank of North America and First Bank of the United States.

His ’moment’ however was assuming the Revolutionary War debts of the various states at the federal level, making the new central authority liable for repayment. This helped create a strong central authority, but equally gave the individual states a positive reason for federalising. They might have ceded sovereignty, but they also ceded their debt obligations. Liberty, after all, has a price.

The statecraft of Alexander Hamilton therefore placed the new and relatively precarious United States of America on the path to greatness. But what relation does it bear to the acrimonious European summit in July 2020 which attracted relatively little press attention in the UK?

One of the obvious flaws in the single currency has been its lack of a central treasury and a central finance minister. Hence, tax rates are not harmonised across the eurozone and the normal fiscal transfer of wealth from richer to poorer regions is inhibited. There is a type of fiscal transfer in that the richer nations are net contributors to the budget, and the poorer ones are net recipients, but it is all done through the contributions to the central EU budget at a national level. The EU has not historically been able to raise money in its own right and has therefore (unlike most national governments) been forced to live within its means. Planned spending increases meant persuading the politicians of richer nations to contribute more to people who cannot vote for them – seldom an easy task.

The newly agreed deal allows the EU to borrow up to €750 billion, with debt issuance through to 2026. Over half of this money will be allocated in non-returnable grants next year and the following year, based upon an assessment of how badly individual countries have suffered from the pandemic effect. Thereafter, assessment will be driven by the hit to GDP in 2020-21, once the figures become clear. Of the total, €360 billion will be allocated in repayable loans from the economic reconstruction fund (Next Generation EU) on favourable interest-rate terms.

Broadly, opposition was led by the ‘frugal five’ – Austria, the Netherlands, Denmark, Finland and Sweden – captained by Dutch PM Mark Rutte, who faces a strong Eurosceptic challenge in Dutch elections next year. The quintet had sought a greater proportion of loans versus grants and to tie disbursements to economic reforms. In the end, the allocation is to be done under qualified majority voting, and the hoped-for veto over national budgets did not materialise. They did however manage to get a slightly higher proportion allocated to loans rather than grants, down from the €500 billion initially posited.

But how to finance this, given virtually every world government has seen their budgets destroyed by the coronavirus crisis? Principally, the EU will raise the money in its own right, but it will be secured against future contributions from member states and is intended to be repaid by 2058. This has the advantage of being zero cost upfront to any of the assembled politicians; the debts will have to be settled by the next generation of leaders, or possibly the one after that. It is also not beyond the realms of possibility that, faced with the prospect of having to repay €750 billion, a future Commission simply decides to reissue the debt for another 40 years.

Possibly more significant, however, was the prospect of an EU-wide tax on non-recycled plastic waste and potential carbon levies on imports from countries judged as having inferior environmental standards, the proceeds of which would go to EU funds. This begins an expansion of the EU’s funding base that is independent of national governments.

At the same time, the EU sorted out its long-term budget to take account of the gaping hole left by the UK’s departure as a major net contributor and the frugal members were allowed to claim some victory by changing rebate allocations to ongoing EU membership fees. Overall, the EU agreed a €1.1 trillion budget to 2027, actually perhaps rather sooner than expected.

How significant is all this? It was a White House Chief of Staff, Rahm Emanuel, who once commented ‘never let a good crisis go to waste’, a maxim the EU has taken to its heart. The EU has long dreamed of being able to fund itself without the tiresome involvement of its constituent nations and although technically speaking the EU has issued very limited debt itself before, this does mark a crossing of the Rubicon. Importantly, the precedent has been established that the EU can issue debt in a crisis.

This will therefore be the default response in the next crisis. The EU will likely continue to issue more bonds until the market decides it won’t buy them any longer, and we are probably at least several crises away from that point, especially as no doubt even then the ECB can always print money to buy them. After all, quantitative easing (QE) used to be regarded as controversial, but the ECB announced a €1.35 trillion pandemic emergency purchase programme on top of all its other QE commitments with barely a murmur of dissent.

The scale of the EU’s current package is not insignificant – Italy and Spain stand to receive around 20% each of the funds, and although they also have to contribute, this won’t be for decades, if ever. Given Macron’s passionate demands over the need for European solidarity on the plan, it may not come entirely as a shock to discover France is the next biggest beneficiary of the scheme.

TS Lombard estimated the fiscal impulse from the grants to be in the order of 6%+ for Greece, 3%+ for Poland and 2-3% for Spain and Italy in the next year or so. But the key benefit for Italy will be in the reduction of its long-term financing rate, and the perceived corresponding reduction in eurozone break-up risk.

The EU has decided it will raise common taxation, and in theory that money should eventually flow through to Europe’s weaker regions, which should also support Italy. The EU has also suspended – for the first time – the Growth and Stability Pact using the ‘general escape clause invoked by a severe economic downturn’. This means national budget deficits are unfettered in a way we haven’t seen in euro history – it is hard to see how, once Italy (amongst others) has escaped once, it will ever be re-imprisoned.

Tax and debt-raising powers have now been accorded to the EU, and that power-ratchet tends to work one way. Technically, this is a temporary programme but as Milton Friedman said: there is nothing so permanent as a temporary government programme. The UK introduced income tax as a temporary measure to fund the Napoleonic wars and hasn’t yet quite found the time to get around to repealing it.

Whilst the frugal five may not be ecstatic about the change, President Macron’s negotiations have moved the EU much closer to a centralised treasury, which will be crucial in keeping the euro stable in the long run. The real world effect can be seen in the chart below, which shows the drop in Italian sovereign spreads over German bunds at the 10 year maturity, and is a proxy for Eurozone break-up risk. The EU has not mutualised all debt – far from it – but the effect is much the same on yields:

It has also been suggested that this does not count as a true Hamiltonian moment for Europe, since the various nations spent five days squabbling in an unedifying manner over who was paying what to whom, and therefore did not demonstrate the requisite European spirit. President Macron apparently banged his fists on the table at one stage, and accused the Dutch of behaving – quelle horreur!– like Brexit Britain. The Dutch also tried to tie disbursement of funds to the ‘rule of law’ in an apparent sideswipe at Viktor Orban’s Hungary, prompting Orban to ask why Rutte apparently hated him. So much for European bonhomie.

However, since Hamilton himself died of a gunshot wound incurred during a political duel, we are not persuaded that his era necessarily enjoyed a kinder, gentler politics, even if EU summits can sometimes be quite brutal.

The bottom line is this is a huge step-forward for European integration, such as President Macron has been pushing for since taking office, but which seemed impossible without a treaty change until the Covid-19 crisis presented itself as an opportunity not to be wasted.

 

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Liontrust Key risks and Disclaimers

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment may involve foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. 

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Issued by Liontrust Fund Partners LLP (2 Savoy Court, London WC2R 0EZ), authorised and regulated in the UK by the Financial Conduct Authority (FRN 518165) to undertake regulated investment business. This document should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.  

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MeDirect Disclaimers:

This information has been accurately reproduced, as received from Liontrust Fund Partners LLP. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.