Good Day,
I am saddened to read the pronouncements in the statement(s) at the linked discussion; of the dismissal and demise of an investing style.
Of particular concern, to the consideration of new investors here; whom we do not know, who read this discussion board. For the more seasoned investor; the statement(s) are obviously, only an opinion; not an investment holy grail.
@MikeM @TedStarting with:
this discussionAs noted in the discussion: "Buying similar funds in the same category for diversification is hog-wash.
Pick a good fund manager in the area you want to be in and go with him or her or that team."
>>> First. I don't agree with the presumption that active managed funds in a given category are all the same and can not offer diversification within a category/sector. If there is little difference in managed funds in a similar category; there is no good reason to invest in these, as an index or etf in that category would likely give the performance required. Secondly, one may always wish everyone well with their available manager choices; and that the managers (assuming a decent prior record used by the investor, for choice) will not trip and fall for some reason going forward with their assessment of market directions.
A sample of healthcare/medical, active managed funds;ranked YTD:
...... YTD..... 1YR..... 3YR..... 5YR
FPHAX +10% +34 +20.8 +26
FSPHX +5.9% +39.6 +23.2 +27.2
FSMEX +3.3% +29.1 +12.3 +18.8
PRHSX +2.8% +31.8 +24.3 +14.5
FSHCX + .2% +22.3 +11 +22.5
FBIOX -1.2% +28 +30.7 +28.9
XLV +4.5% +24 +19.8 +21.4
So, investor "x" feels this investment sector is appropriate for 20% of their portfolio. They had previously decided in 2013, to choose the top 4 funds in the above list, based upon 5 year returns, at that time; and place 5% of their portfolio into each of the four funds. Their fund choices were: FBIOX, FSPHX, FPHAX, FSHCX
The funds, as a blend; still have a decent return YTD, in spite of some stumbles in certain sectors. Whether the investor may have done better with just one broad based fund is only of value in hindsight; unless they have an impressive magic 8-ball device for future answers.
'Course, if buying similar funds in the same category is a waste of time, reportedly hog-wash; perhaps skipping an active managed fund and investing in an index or etf is an equally decent choice, especially if the e.r. is very small.
Confirmation of the variables of performance of active managed funds may be found at this
health funds list. The list is sortable with the column year returns. All one has to do when choosing one fund with which to invest is; well, do your homework and hope that nothing changes with the management or style of the fund going forward, so that one may keep the faith.
Oh well, to each their own.
Take care of you and yours,
Catch
Comments
The point isn't that choosing 3 or 4 of the ones you listed is no better than choosing any one of them especially when they may not be all fully correlated but rather that the more of them you chose, the closer its performance will be to an index fund broad enough to cover all of them. For example, how does your selection compare to just buying XLV or VHT or IYH instead which have allocations overlapping the set of 4 funds chosen?
The only possible objection to the earlier point is that a suitable index fund to cover the set of funds may not be available at all. For example, consider diversifying between two merger and arbitrage funds. There is no index to buy instead and you may still want to reduce the management/strategy risk specific to any one of them.
The more mainstream the asset class or more generic the strategy, the smaller the number of funds with the same asset class or strategy you can buy before they start to look like an available index fund that covers all the asset classes in those funds.
(2) While I get the point about approximating "index fund" status as more funds are added, when carried to the logical extreme this would argue for owning just a single fund.
So I guess I stand by what I said. Pick one good manager with proven results in the sector or categories you wish to diversify in - and stick with him. Don't dilute his abilities to index returns.
Thank you, as always; for your observations.
Perhaps I should have waited until Sunday morning (now) and not late night Saturday (too tired) for the write. I didn't place the thoughts as a rebuttal; but understand how this may be viewed, as such.
I just don't agree with the pronouncement that this particular method of investing with holding more than one active managed fund in a given sector is a worthless mode.
I did list XLV in the list with the other health sector funds for a compare.
As to my thoughts regarding the original write; well, there are many methods that are valid for many investors to obtain performance suited to their risk/reward and observations.
I did not note, and should have; that using perhaps 3-5 active managed funds for a given investment area is a hedge against "management malfunctions". Knowing that any given active managed fund holdings are not going to be an exact fit into a M* category may open the investment door further. This is where the investor must do their work to help determine, of what, a fund consists.
An example would relate to a few of our bond funds: LSBDX, PIMIX and FTBFX. These may be considered "total, multi-sector or choose a favorite word". The point being is that there is likely some overlap somewhere among these 3 funds; but I am not concerned. The 3 funds do operate in different bond worlds most of the time.
These 3 funds, their methods, holdings and management give us diversification in this investing sector.
Heck, in the end; with the consideration that investing in the U.S. moves one into the best of the "turd" piles globally, our house could place a 50/50 bet with something similar to VTI and AGG and let them ride forward, come hell or high water. Their averaged returns over the years would keep one above inflation and tax rates, for a small net gain.
Now, returning to home remodel.......a most fun sport.
Take care,
Catch
Regards,
Ted
-Fini-
First, there are two funds A & B. Should you buy just one of them or both? Forget the indexing alternative for now.
It depends on what they are and what the goal is. It is at the heart of diversification.
So as not to confuse with @old_skeet's betting analogies, are A & B in a zero sum game? For example, a fund and its inverse. In this case, it makes no sense to buy both. The expected return is zero. You can make the case that this is better than buying just one of them and being wrong. But so is not buying either.
Obviously, the case for buying both is that the expected return from buying both is a positive expected return and so, it is not a strictly zero sum game. While you will do better than the worst of them in any period, you will do worse than the best of them. But since you don't know which one of them will do better, all you have done is to reduce the variance of expected returns at the cost of highest possible return.
This is the heart of the diversification thesis whether it is multiple funds, multiple stocks or multiple strategies. It applies to @old_skeet's sleeves or pooling in lottery or parlay vs single bets, active funds or index funds. It may increase risk-adjusted returns but not possible absolute returns.
This is what works for people ... to a limit. Diversification has a point of diminished returns so adding more will not lead to more benefits. If two funds are highly correlated, then there is no benefit to buying both.
This is the basis of the argument from @catch22 and @old_skeet.
There is a different problem of whether to buy a basket of active funds or an index fund instead. This is a different issue than buying just one of those active funds as described above. This is where @MikeM has a valid point. The more active funds you add in the same or largely overlapping asset classes, the more the resulting combinations begins to look like an index fund if available to cover the asset class used. But this is NOT an argument by itself that says you should buy just one of those active funds instead (as opposed to just buying an index fund). This is where the disconnect is in how people are interpreting it.
There is an unsaid (or not understood) assumption behind @MikeM and @Ted on buying just one of the active funds. The reason for buying an active fund in the first place. You buy an active fund to gain an advantage from that manager in that asset class over an index fund, whatever that advantage is. But you potentially realize that advantage only by accepting the idiosyncratic manager risk (i.e , unrelated to market risk). If you try to diversify away that risk by buying multiple managers in that asset class, then you have potentially given away the advantage as well and approaching the risk adjusted returns of an index fund. So why buy an active fund at all?
The suggestion to buy just one of the active funds instead is to explicitly tell you to take that additional risk to justify the higher potential returns, not to say it is less riskier or the same as buying an index fund. The betting analogies aren't the right ones to use here because unlike betting avenues you have more control over the risk you take in an active manager from research and it isn't a zero sum game amongst the contenders like most betting avenues.
The argument of multiple funds in different asset classes with only minimal overlap is a red herring to this discussion. The difference in market risks dominate that scenario and diversification helps.
My feeling is that these kinds of discussions come about when people see portfolio construction as primarily a fund selection activity than as an asset allocation activity.
Yup - Don't know what got into Old Skeet today. Probably shanked too many balls out on the golf course this morning. But, his contributions are always greatly appreciated - even if sometimes a little off the fairway.
No one invests if the expected value is zero or negative. If you buy two funds, you are expecting both to be positive over the long term but moving differently. Two asset classes that are not correlated can dampen volatility. The reason for two similar active funds is to avoid manager/strategy idiosyncratic risk. This is a little different from the volatility dampening diversification.
That's pretty much what I was trying to say.
The volatility of a fund is a combination of asset class volatility and manager strategy (focused, capital protection, etc) induced volatility. Asset class volatility is managed by buying different asset classes that are not hopefully correlated.
Active funds tend to magnify (focused or concentrated funds) or diminish (capital protection or drawdown management) this volatility with manager strategy. This "multiplier" can be managed by just the allocation amount to that fund to suit your volatility tolerance because that multiplier is reasonably constant. You don't need a diversifier within the asset class for this reason paying the performance penalty.
The problem with idiosyncratic manager risk is one of failure of the strategy for some economic condition. And yes this failure can result in volatility
The good news is that such failures of strategy are not common. While there are no guarantees in life, with some reasonable research, one can avoid funds that are prone to such failures rather than try to diversify that risk away and lose the edge any such fund brings over an index fund.
Am I making sense to you?
Can't draw pictures like @bee but visualize the price volatility line of a fund in a graph in two parts, the volatity of the underlying asset class and the wiggles around that line from the manager/fund family strategy (+/- alpha). The latter is small compared to the former. This is the distinction I am trying to get across.
Note that M* categories span pure asset classes or strategies. So, the funds in the same category might have different implications for combining funds.
In the latter case, where the category is based on strategy (such as allocation), the underlying asset class can vary as you have pointed out in your example. When you combine them, you are progressively approximating the volatility curve of an index that combines all the asset classes in the two funds and the individual alphas from the two managers get diminished relative to this. So you have moderated these tiny volatility wiggles at the cost of decreasing the thin alpha they might be able to realize individually. The question is whether it is worth doing this if you ignore a fund meltdown scenario (an unexpected BIG wiggle) for the strategy.
In the former case, if you add more funds with the same asset classes, these alpha wiggles start to even out and merge into the asset volatility curve. Adding two large blend funds for example will do this. So trying to even out those manager/fund family wiggles with diversification is not very productive here either. You can achieve the same smaller volatility by a smaller allocation to either one.
So, in reality, the motivation isn't really as much reducing volatility (although this will happen as above) but rather avoiding unexpected drawdown (more than the typical volatility of the fund) due to a potential failure scenerio in the manager/family strategy.
I am.distinguishing those two cases though both can be included under volatility. The latter is a valid reason for betting on two or more managers especially if one of them is a hit or miss kind of manager. But the cost of doing so may still destroy the alphas of either manager/fund.
There is an argument that can be made that perhaps it is better to take that less likely fund/manager/family risk by just buying one in a category to realize the full benefits of that active management. But reduce the impact of any meltdown in that fund via diversification with other asset classes or categories in the same way you diversify to protect against a breakdown in any one asset class.
At the minimum, it might encourage a more careful analysis and understanding of the fund to select than in a kitchen sink portfolio with multiple funds in each category.