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Diversifying investment styles pays off

DIVERSIFICATION is widely accep-ted as one of the fundamentals of good financial management: “Don’t put all your eggs in one basket”, we are frequently told.

But what does this mean in practice? How far should investors take the concept?

There are two aspects to diver-sification that most investors would be familiar with, but there is a third aspect many would not have considered.

First, investors should diversify across the main asset classes. This means putting some of their money into shares, some in property, some in cash and so on.

The amount of money going into each asset class will depend on each person’s risk profile and financial goals.

Second, investors should diversify within each asset class. For instance, they should hold a range of shares across different industries so they are protected from a downturn in a particular company or industry.

Many individuals have achieved this diversification by investing in managed funds, such as Perpetual’s Industrial Share Fund or Colonial First State’s Imputation Fund.

By purchasing units in these funds, investors get a small stake in a large, professionally managed share portfolio.

So far so good. But how many people have thought about the investment style of their fund manager? This is the third aspect of diversification and it can have a large bearing on the risk-return trade-off.

Perpetual, for instance, is known as a ‘value’ manager. It seeks to buy stocks that are undervalued by the market.

The undervalued price could be due to the market over-reacting to bad news or negative sentiment to a particular industry sector. As the stocks are re-rated by the rest of the market, their price should rise.

In contrast, Colonial is a ‘growth’ manager. It seeks to identify companies that achieve growth in profits that is consistently higher than the rest of the market.

As the companies report higher earnings, their price should rise.

In practice, ‘value’ managers and ‘growth’ managers tend to lead the market at different times. It is rare to find one manager or one style that consistently outperforms all others.

How should individual investors respond to this dilemma?

Deutsche Asset Management has been selling the message that investors should use several fund managers with different styles.

In this way, investors should be able to achieve consistently high returns with lower risk – which in this case means lower fluctuations in annual returns.

Deutsche’s Craig Hobart describes his firm as ‘style neutral’. Its key criterion when selecting stocks is to identify companies with strong long-term cash flow generation.

This approach makes it an ideal candidate for investors who want to use three or more fund managers with different investment styles.

Individuals can implement this strategy by investing directly in retail managed funds, most of which require a minimum investment of $2000.

Alternatively, they can utilise a master fund, which gives them access to wholesale as well as retail funds and makes it easier to switch money between different investment managers.

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