Is it time to diversify?

Hi guys,

This is a question I was contemplating putting to my financial planner, but thought I would put it to the collective mind of InvestEd first in hope that you might all "teach me to invest", and maybe some others can benefit from the conclusions and thinking too...

Diversification definition:

OK, diversification is an easy principle to understand. Basically, by spreading your investments across asset classes or even across assets within a class, you can reduce your risk whilst maintaining your expected returns. If you take too conservative a position in any one class of asset then you miss out on some returns but reduce risk. This is sub-optimal. Its better to just diversify your higher risk assets in order to reduce your risk. If you need more information on this topic I'm happy to post it in detail if requested to do so.

My current situation:

My current asset allocations is nicely balanced between property and the equities markets. I have $800K invested in property (my PPOR) as well as $600K invested in equities (NavTrade Retail). I think this mix of classes is about right, but have been thinking about diversifying my investments in the equities market. I'll explain my reasoning...

1. I have tracked the performance of my single managed fund for the past four months very closely to understand how this vehicle performs relative the market. To date, it appears from observation and dialogue that it is a "capital secure" investment that "under-performs" in a rising market. Capital secure funds should be the first port of call in anyone's investment kitbag so please don't think that I am suggesting this is a poor fund to be in. I've posted a graph of the performance of this fund over the last four months for reference. Basically, the market has done all the heavy lifting over this period rising about 10%. My fund has only risen about 4% at an opportunity cost of 6% in under-performance to the market.

2. I think it might be time to find a high yielding growth managed fund with a good negative correlation to my capital secure low yielding fund. This fund would be less capital secure, but would give better returns in a rising market. Basic financial literature would suggest that this would increase my expected returns without increasing my risk substantially (standard deviation of these returns). For those interested:

ER(portfolio) = (%f1) ER(f1) + (%f2) ER(f2); and

The variance of the portfolio is the weighted sum of the variances plus the weighted sum of the covariances (don't know how to insert latin characters here so can't write the formula sorry ).

My questions:

Basically, I believe my current portfolio is risk averse (good thing) but at the expense of expected returns (not so good thing). I think that basic diversification logic suggests I can significantly increase my returns (good thing) without significantly increasing my risk position (good thing). But this requires I find a good negatively correlated fund for optimal diversification benefits.

So my questions are two-fold:

1. Is my logic accurate such that diversification of my equities is now appropriate?

2. Does anyone here know of a good high returning fund that they would suggest is negatively correlated with the NavTrade Retail fund?

Many thanks in advance,
Michael.

 

Sim,

Actually, the latter is closer...

Remember, both of these funds should have a high average expected return over the long haul. But, when one is booming the other should be taking a breath and vice versa.

So, lets assume that Navra does an average return of 10%pa with a standard deviation of +/- 10% (i.e. can do 20% in a good year but as low as 0% in a bad year). If I were to pick another less capital secure fund I might expect returns something like: expected return 15%, standard deviation +/- 20% (i.e. can do 35% in a good year but as low as -5% in a bad year.

The power of diversification would suggest the following for a perfectly negatively correlated relationship (i.e. when one goes the other falters):

E(r) = (0.5)(0.1) + (0.5)(0.15) = 12.5% pa; and
S.D. = SQRT((0.5)^2(0.1)^2 + (1-0.5)^2(0.2)^2 + 2(0.5)(0.5)(-1)(0.1)(0.2)) = 5%

i.e. This portfolio would give me an expected return of 12.5% pa with a standard deviation of +/- 5% (i.e. can do 17.5% in a good year but as low as 7.5% in a bad year).

Comparing this with the Navra only position you can see that the average expected return is higher (12.5% > 10.0%) AND the standard deviation is lower (5.0% < 10.0%). So, the portfolio is better on both counts to investment in NavTrade retail alone.

The trick is finding a nice returning negatively correlated fund. However, I don't think this is impossible at all.

Cheers,
Michael.

 

Of course it's possible...with the benefit of HINDSIGHT.

I tend to think that diversification beyond a certain point = diworsification. (I think it was Peter Lynch who coined that term??)

 

Nigel,

Agreed that diversification beyond a certain point stops reducing your standard deviation significantly but does start limiting your potential returns. At the moment I am not diversified at all though, I have all my eggs in one basket. One fund with a single (DCT) methodology.

This fund is stated as not being ideally suited to a bull market but a strong performer in a bear market. I think I need to find a strong performer in a bull market and an under-performer in a bear market to get some diversification benefits.

Regardless of the bull/bear market, whatever I invest in must average at least 10% over the long haul to be viable. Given we're in a bull right now, I'm underweight in small caps so am weighed down by the conservative nature of my current portfolio.

And its not hindsight. I intend to invest for the foreseeable future so action taken today will yield benefits for years to come. Hindsight is simply informing my active decision today.

Cheers,
Michael.

 

Michael
Im in a similar position and have looked at otherfunds to diversify
I note you dont have Ip, and a PPOR
So I assume you are pretty tax sensitive
Navra will underperform even more once you take into account tax
as distributions are taken as income by the tax dept hence taxed at your tax rate - which may be 48%
I note you are also benchmarking yourself against the index when working out the opportunity cost. When you take into account tax - the cost is a lot larger
So why not put some of your portfolio into vanguard index aus fund - and do it after a correction - long term you know it will meet your goal of >10% return
The otherway to go for indexing is STW on the stock exchange. www.streettracks.com.au - a cheap way to get in and also you can set stop losses with an index Exchange traded fund
Ive added a bit to LIC's ie AFI,
am looking at argo - but a bit overpriced now, and also milton
see the aegis report - www.aer.com.au - bottom right for a review on LIC's

This would reduce risk of the portfolio, and enhance tax efficiency
Then add some for growth - aiming for up to 1/3 of portfolio - probably a little less - international funds - I like platinum - I have invested in Brands, then Asia fund, and international
- these have performed 20-45% in the last yr

Then some to local stocks - BHP if you believe in asian growth, resources

Still my holding in navra is still way too high, and I am thinking of selling some off to improve returns.

With IP, and margin loans you need to watch your yield
so LIC's, navra, dogs of dow type stocks, property funds/index

So in summary my approach is
add indexes as a core, to improve tax efficiency, buy on slumps - vanguard or STW, low risk
LIC's proven long term outperformance, low risk
navra - for yield, if on margin, or via LOC
international - to protect against a slump in aus market,
Asia for growth
energy possibly for growth
property funds for yield
dont have >50% in any one area

I wouldnt go with geard funds - as Im geared already, and it just adds to risk.

 

Michael,

Trends are not infinite and they come to an end one day.
Do not forget that in the bull market (like we have for the last 3 years), stocks go up (everybody makes money) and in the bear market all stocks (almost all of them) go down (almost everybody loose money).

In the case of diversification, all depends who are you talking to because there are as many believers in diversification as there are against it.
If you believe in diversification ask yourself how long the current trend (bullish) will last...
As far as I know most of the funds prefer buy and hold strategy no matter what, and this kind of approach is proven to be a disaster during the bear run.

If I understood correctly you would like to switch your money from the fund performing well during the bull market to the fund performing well during the bear market (or have your money in both funds at the same time)
It's a good idea.....as long as you can specify with a big accuracy (predict ) WHEN market reverses and for how long!!
Question is: Can YOU do it ?

 

Hi Michael,

In what way do you see the Navra Fund as 'Capital Secure'?

If you'd just bought Navra Units and the Stockmarket took a 15% fall over the next week, you're not meaning that your Capital via the Unit Price would be preserved are you?

 

Hi Michael,

At one stage I was going to put 100% of my money into Navrainvest. My financial planner advised me 40% and I took that advice. I'm glad I did, in fact I wish I reduced it to 25%. I don't really need the quarterly distributions, they're not tax effective for my situation. If I had my time again I'd have put more than 10% of my money into Platinum International. Not only are do I diversify into International shares with them, but they have a bloody good track record. Alternatively I could have put more money into Hunter Hall's Global Ethical Trust

Nonetheless, in raw terms Navrainvest has been going very well, it's just that some sectors have performed better. Whether they can continue to do this is the question.

 

dkmc,

This is precisely the sort of information I was looking for. Thank You! And Glebe, thanks to you too for the recommendations. I particularly like the look of platinum international.

Here's what I think I need to do now:

1. Reduce my exposure to one market, one fund, one methodology by selling down my holding in NavTrade Retail in the ASX200.

2. Rebalance my portfolio initially to an even thirds mix of three different funds. I will further diversify this as time progresses and I can better understand the relative merit of adding other options to my portfolio mix.

3. Initially, I am thinking equal thirds in:

A) NavTrade Retail: ASX200 based fund using a DCT methodology which is a relatively low risk fund with average returns. High weighting towards income over growth.

B) Platinum International: International markets fund using a value based methodology. Medium risk fund with high returns. Weighting towards growth over income.

C) Listed Index Funds: ASX200 based funds using a value based methodology. Medium risk funds with high returns. Weighting towards growth over income. I'm thinking Milton (MLT) because of their high wieghting towards the finance sector as a hedge, as well as StreetTracks ASX200 (STW) due to its strong correlation with the ASX200 accumulation index (XJOAI). In time would also like exposure to Argo (ARG) as well.

What are your thoughts on this initial mix of funds? I have decided on A) and B) but would welcome suggestions around alternative C). I'll continue to post how I get on with this diversification here, and also will compare the post-diversification results to the pre-diversification results in another thread if others are interested.

Once I lock in a decision on all three funds to diversify to, I will then look at how I make this transition given the need to borrow from a margin lender etc. and sell down existing margined units. (Simon, if you're reading this I might need your help here).

Thanks again,
Michael.

 

Alan,

Good point. I guess I was "talking it up" a bit more than appropriate. Lets just say that it is "likely to outperform the index in a falling market". By no means makes it "capital secure".

Cheers,
Michael.

 

You might want to give Tyndall a squizz.

That's NOT a recommendation, just a suggestion for another group to look at.

Mark

 

Have you done the maths on selling down vs getting your distributions in cash and subsequently buying units in other funds quarter by quarter. Will it get you where you want to go to quick enough, as selling down always sounds drastic to me. There's capital gains tax and it wasn't long ago you paid entry fees.

 

Managed Fund selection

Hi all,

I have recently researched managed funds to make an investment through our HDT. I have found the following 3 tools very useful:

Morningstar:

http://managedfunds.hsbc.com.au/Tools/CoBrand/mlhsbc/MLHSBC_QS.asp

See also Morningstar Top 10 Performing Retail Funds and the article “Why You (Probably) Shouldn't Own This Website's Ten Top-Performing Funds” :

http://www.morningstar.com.au/Tools/General/Includes/FundResults.asp?cobrand=MS&cid=MS&tid=true

http://www.morningstar.com.au/templateslocal/displayArticle.asp?id=2415

TradingRoom:

http://www.tradingroom.com.au/managed_funds/index.jsp?section=find_a_fund&page=/servlet/FundsServlet&sy=tpl&tax=mf&cmd=spb

InvestSMART:

http://www.investsmart.com.au/funds/search.asp

Enclosed is the shortlist of the funds that I have combined and then looked into to choose a few to invest. The figures are 1 month old.

<<Funds.xls>>

You are welcome to try different sort combinations to find your piques.

I have finally come to the following funds:

CFS MIF - Global Resources Fund (Colonial First State Global Resources Fund)
CFS MIF - Geared Share Fund (Colonial First State Geared Share Fund)

There was one more fund - Macquarie - Emerging Markets Share Trust – that unfortunately was closed for new investments.

I like Platinum funds and was wondering why a few people on the Forum were keen to invest in Platinum International Fund, but didn’t mention (for example) Platinum Asia Fund, which seems to perform better:

http://www.platinum.com.au/reports/web_all.pdf

I welcome any comments and references to other tools and specific funds that are worth investigating further.

 

Hi Dkmc,

How do find Navra vs Property funds. They're both in the yield game and both can be leveraged to similar amounts.

 

Maverick,

That post and all the information you supplied was excellent, thank you!

I like the Platinum Asia fund, and I've read extensively that Japan is still likely to be the lead market in 2006, but it is starting to peak. Australia will also outperform most of the world, so both these markets make good sense in the short term.

One issue with the Platinum Asia fund is that it hasn't been around nearly as long as the Platinum International fund. That makes its returns less reliable due to the lack of a long term proven record in those markets.

But it is definately something worth considering too as your "foreign market" exposure.

Cheers,
Michael.

 

For me I was just happy to keep it broad and generic. Platinum has quite a few more specialised funds, but I didn't want to try and guess this way or that. I just kept it simple.

 

Hi all
Another tip
www.tradingroom.com.au
has a wonderful tool for managed funds
It allows you to keep a watchlist and portfolio
with entry dates and daily tracking
It even includes navra so you can track performance over time

I dont know if im allowed to post a picture of my watchlist from the site, but anyone wants to pm me I can email them

again not advice just opinion

platinum brands does a lot better than platinum international over 5yrs
consider holding both


oh read
http://www.travismorien.com/FAQ/main.htm on portfolio construction
http://www.travismorien.com/presentations.htm


actually I will be using travismorien in future, for share portfolio construction. He has some excellent ideas

oh when you buy platinum, make sure u arent wacked with eny entry fees
cheers

 

Hi Glebe
Im no expert in that area, Yes that is true.
Different areas of the market tho
Navra is churning the share market for volatitility
I dont hold any property funds at present
Maybe I should

I know Peter spann has used unlisted property trusts for a much larger return. Anyone investigated this area.