October 23, 2006

Causes of underperformance not what they appear
Dilution trumps star-chasing

Many in the industry, me included, have trumpeted the fact that investors' portfolios haven't done all that well in aggregate. The statement refers to the gap between the good performance of markets and many funds compared to investor returns. Why the gap? We have often cited problems such as "overlap of holdings" and the tendency of investors to "chase hot funds". I don't think that there's as much merit in those causes as first believed. I'd put my money on portfolio dilution as the main culprit of investors' underperformance.

Overlap

I've often heard the following to explain a portfolio's underperformance, "You have too many funds doing the same thing .. you have too much overlap". I'm sure that I've uttered those words in the past but it's not quite right. Holding two funds that precisely overlap each other - not only same style but same holdings - poses no problem as long as exposure to the funds and the asset class are suitable. Rather it's where there is style and mandate similarity but without perfect overlap that portfolios run into trouble.

Admittedly this is something of a play on words but the distinction between overlap and dilution is important. Overlap of holdings is fine as long as the total portfolio exposure is suitable. Dilution results from holding two or more similarly managed funds holding like but not identical stocks (i.e. large cap Canadian).

To some extent you could consider this simply an exercise in diversification but it doesn't take long before portfolio dilution (or di-worsification) kicks in. This is where the portfolio risks becoming more index like but with active management fees. That will doom any portfolio to long-term underperformance.

High turnover and trend-chasing

I have often cited investors' infatuation with hot funds or sectors as a source of underperformance. This is true of narrow-mandate funds like those investing in China, precious metals, and the like. Star-chasing still happens but in aggregate this is not the problem I was once convinced it was for Canadian mutual fund investors.

Poor timing indeed is a contributor to underperformance but I'm not so sure it's the biggest contributor. Indeed, the holding period of Canadian long-term mutual funds (all funds except money market) is reasonably long at 6 to 7 years, on average over the past thirteen years. In fact, this (asset-weighted) average holding period has nearly doubled since 1993. And in past periods of significant market declines, mutual fund investors tended to trade less - not more.

Given these facts, is it plausible that mutual fund investors are making huge trading mistakes? I think not. Sure, the timing of purchases is often not great but a sufficiently long holding period can diminish the impact of timing. So what's the problem? It's related to the dilution issue discussed above.

The industry's bloated line-up of products is to blame. Let's look at the entire fund industry as one gigantic portfolio. If we do that, Canadians are holding hundreds and hundreds of unique funds just to invest in Canadian stocks. I would never recommend that any investor spread money among hundreds of funds - particularly in one little asset class. And I have opined in the past that at least 90% of funds are probably not worthy of investors' dollars. Accordingly, investors in aggregate are bound to underperform.

Diversification is a critical component of sound portfolio construction. Advisors must strike the delicate balance of having sufficient diversification (to reduce reliance on any one stock) with the need to stay focused enough to make active management worth paying for. Dilution (a.k.a. di-worsification or excessive diversification) can result in an expensive, index-like portfolio. Too focused a portfolio can incur too much risk (making success more uncertain).

Striking the right balance is key and it's admittedly far from a pure scientific exercise. While I can't give you the definitive answers, the above issues should be top of mind during the portfolio construction process. For advisors it's important not only for each client but for their whole books of business.