But it’s important to understand the best way to achieve diversification. Some mistakenly see diversification as a simple numbers game. The thinking goes that if you make a large number if bets, the odds are slim that they’ll all go south at the same time. It’s that reasoning that prompts many investors to shy away from concentrated equity funds in favor of funds that spread their assets o
ver a large number of stocks. But will a large number of holdings really protect a fund from volatility? Not necessarily.
We recently took a look at all the funds in each UK equity category with at least a five-year performance history to see if those with the most holdings provided a smoother ride to their shareholders. We used standard deviation of returns as a measure of volatility. Our research showed that there was little correlation with number of holdings and standard deviation. Sure, some funds with large portfolios were able to attain a low standard deviation, but others with just as many holdings experienced more than their share of volatility. On average, the funds with the most stocks were no more or less volatile than the typical fund in its category. The one exception was the Morningstar UK Large Blend category where funds with lots of holdings, on average, had slightly lower standard deviations than the category median. This was largely due to the presence of extremely large portfolios with 400 or more stocks. (Not surprisingly, most of these were trackers.) But the difference was not dramatic; these very large portfolios managed to blunt volatility only slightly.
Interestingly, when we measured diversification by the percentage of stocks held in a fund’s top 10 holdings, we got very similar results. So neither measure of concentration—number of stocks and percentage of holdings in the top 10—provide a foolproof screen for low volatility funds.
Neither proved to be a silver bullet for finding resilient funds either. To see if funds with large portfolios held up better during down markets we looked at the downside capture ratio, which shows whether or not a fund has over- or underperformed the market during downturns. Once again, we found that lots of holdings didn’t necessarily protect a fund during bear markets. Indeed, funds with lots of holdings haven’t held up better, on average, than more concentrated rivals during the most recent downturn. For example, over the past year, those UK large-blend funds that rank in the top 10% in terms of number of holdings have lost a little over 29% on average. That puts them right on par with the category average.
So clearly diversification isn’t purely about numbers. Rather, diversification comes from combining assets that have very little correlation with one another. In that way, when one area is suffering (like financials and tech stocks over the past year) another area might hold up a little better (like industrials). Accordingly, a fund that owns many stocks might still be volatile if it makes big sector, style or market-cap bets.
Looking beyond stocks, your overall portfolio can benefit from the same principle. If you own a mix of uncorrelated or mildly correlated asset classes—stocks, bonds, real estate, commodities, for instance—returns are likely to be smoother because one asset class is likely to zig when the other one zags.
Granted, there haven’t been too many places to hide amid the current onslaught, but a portfolio diversified across asset classes should help keep a lid on volatility and improve your risk-adjusted performance over time.
