Ah, the 80s: the music, the movies and…the utter disregard for road safety. Despite an average of 2,700 people dying every year in car accidents in the UK, seatbelts only became mandatory in 1983 and back seat passengers had to wait until 1991 to be officially strapped in. Since then, there has been a steady decline in casualties.
As financial writer Morgan Housel loves to point out, it can take a surprising amount of time for social norms and attitudes to change in response to what are, at least with hindsight, obvious improvements: the modern seatbelt was introduced back in the 1960s!
I believe that a similar example of this resistance to change is posing a risk today, this time to the safety of UK investors’ portfolios.
How?
It is now widely recognised that the period since the credit crunch of 2008-9 was highly unusual in economic terms: interest rates were very low, and QE-driven money-printing forced investors to chase yield. The result was that long duration investments such as long-term government bonds and growth stocks benefitted disproportionately.
Then 2022 hit. Inflation and interest rates rose significantly around the world and there is little evidence to suggest that portfolio managers, or clients, have done anything to adjust their portfolios accordingly.
Even more concerning is that the behaviour of markets over the last decade may have caused a convergence in how portfolios are positioned. I have become increasingly suspicious that many investors may not be as diversified as they think they are.
To understand why, consider what happens when markets trend strongly for long periods of time. At least three “convergence dynamics” kick in:
- Managers who are running a contrarian style underperform the benchmark and gradually lose more and more clients as the trend continues.
- Meanwhile, more flexible managers adapt to be more in keeping with the times (I remember an institutional consultant telling me a couple of years ago how EVERYONE now described their philosophy as “Quality Growth”).
- The above two phenomena feed off each other, as the selling pressure in the underperforming stocks continues.
Valuation data suggests that this is indeed what has happened – valuation spreads within the stock markets are still close to record highs suggesting a big gap remains between the cheapest and most expensive stocks.
However, to verify whether this is a true problem, I looked at five of the largest funds in the Investment Association’s 40-85% equity fund sector. This is a large and widely used category of funds that includes the classic 60/40 benchmark; I took the largest passive fund as a proxy for the benchmark, alongside the four largest active funds.
As of the 31st May 2023, these five funds combined held £28.6bn of UK savers’ money with a heavy skew towards the passive offering from Vanguard:
With some help from Morningstar’s data, I then looked at the correlations between each of these funds over the 10 years to 31st May 2023. A correlation of 1 means that funds move in an identical manner and -1 means that two funds move in the opposite direction.
As you can see from the matrix below, each of the five largest funds has a correlation with the other members of the group ranging from 0.85-0.95:
On average these largest five funds are 90% correlated with each other. Ninety percent!
To quote The Terminator (1984), “This is not good”.
An investor splitting their portfolio equally between these funds may feel they have achieved some diversification whereas, in practice, the funds’ performance has been so similar, that the diversification benefits would be minimal.
And this is where the money is. These five funds account for nearly three times the level of assets under management held by the next five largest active funds in the category. And, even if your holdings were to be spread across these extra funds, the average correlation would barely change.
You get a similar conclusion when you look at the drawdown statistics.
This data clearly suggests that a large chunk of UK investors’ money is driving around without the ‘seatbelt’ of true diversification.
So, what can you do?
Firstly, check the correlations of your largest holdings. If they are high, you may want to consider introducing more variety into portfolios.
Secondly, look beyond the largest 10 funds. Size doesn’t matter when it comes to investing, unless you are a passive fund. While it makes sense to have some passive in your portfolio, the founder of Vanguard, and the father of passive investing Jack Bogle himself pointed out: skilled active managers tend to be those who focus on managing rather than marketing, as well as limiting the size of their funds.
Thirdly, buckle up. The last 10 years have been terrific for investors. But, those returns have pulled forward a lot of future returns. The real benefit from diversification comes from smoothing out the returns, particularly when markets get choppy.
Dan Brocklebank is director UK at Orbis Investments
