Niche funds can get too big

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From diversification to broader allocation rules, any discussion of portfolio construction can seem quite academic when most assets are bullish. However, heavy falls like those seen this year can expose all sorts of vulnerabilities – including the risk that holdings of funds with a more specialized approach, many of which have propelled portfolios in recent years, will prove particularly painful as the markets turn.

These results can sometimes happen almost accidentally. For those following the core/satellite investment approach of placing the bulk of their money in well-diversified holdings while adding smaller, more specialized holdings to the margin, it is important not to let inadvertently a more specialized fund becoming too large a part of a portfolio. Here we take a look at some names that may have become too prominent before the sale, and some that may become so in the future.

The general popularity of a fund is not a reliable indicator that it has become a top holding in most portfolios: a large number of investors may simply be exposed to relatively small amounts. But Scottish Mortgage Investment Trust (SMT), the largest UK trust by market capitalization until very recently, is likely to have been seen more as a core holding in recent years. Although some would argue that it is a basic holding, its high octane characteristics and focus on certain growth sectors mean that position size should be reduced or holdings avoided. similar, are important factors to consider.

As Charles Stanley’s chief analyst, Rob Morgan, put it: “A typical fund or trust in the global equity sector would be a good core holding, but Scottish Mortgage has a high level of volatility due to its very defined high growth style, as well as gear. and fluctuations in the discount to net asset value in addition. This would tend to make it a satellite [position in a portfolio]let’s say about 5 percent.

This article was previously published by Investor Chroniclea security held by the FT group.

There are nuances, Morgan acknowledging that Scottish Mortgage could be a bigger stake – in the right context and with certain conditions.

“Assuming a portfolio is well-diversified across various asset classes and geographies, and is for a long-term investor able to handle a more adventurous level of risk, having Scottish Mortgage as more of a holding base, say 10%, is a possibility,” he said. “But if you did that, you wouldn’t want anything else in the growth/tech space on top of that.”

A Scottish Mortgage shareholder would sit on a one-year paper loss of almost 35% as of August 2, which would likely shrink his size in many portfolios. Yet the investor who eagerly rebalances his original allocations after a major market move, or who has begun to eye the discounted growth funds, should always be wary of position size.

Another popular type of investment fund that could have risked becoming too big is the theme fund. In the ETF space in particular, thematic strategies, which invest in a particular trend or theme instead of focusing on a specific region, have attracted billions of entries in recent years. Names like the iShares Global Clean Energy Ucits ETF (INRG) have been particularly popular, but still represent a niche for all but enthusiasts of that particular industry. Although it has a larger number of holdings than some competing funds following an overhaul of its underlying index, this iShares ETF, like its peers, invests in a very niche space.

“Clean energy suffers from the fact that its investment universe is quite small and the opportunities for effective diversification are very limited, so it should be a satellite holding,” notes Tom Sparke, investment manager at GDIM. “This would also be the case for other niche themes such as cybersecurity or semiconductors; these are building blocks, not the complete package.

As with Scottish mortgages and ESG-leaning funds, many thematics took a beating in the recent sell-off. This can provide a potential reset for any investor who has become overexposed. It should be noted that deploying new investments in different holdings may be a more sensible way to rebalance these holdings rather than selling them at a loss.

With investors looking for effective diversifiers and only a number of funds making gains, there is a risk that another imbalance will emerge. Asked about other areas that could become too large in portfolios, Morgan mentioned gold, energy and natural resource funds.

Similar thinking may apply to other sector-specific players as they gain popularity, from financial funds to biotech trusts that have sold off strongly over the past year. Ultimately, portfolio construction rules for diversification and rebalancing can pay off when extreme market moves occur.

“This is an example of the benefits of rebalancing, of not letting positions get too large to continue to dominate returns, and of not focusing too much on past performance. People are likely to buy what worked well rather than what is appropriate for building a broad portfolio,” Morgan said.

*Investors Chronicle is a 160-year-old publication owned by the Financial Times providing expert, independent insight into the investment market. It provides educational features, investment commentary, practical advice and personal finance coverage. To learn more, visit investorschronicle.co.uk

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