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How diversification can help to reduce risk

Mar 27 2018 07:15
Schalk Louw

Schalk Louw is a portfolio manager at PSG Wealth. (Picture: Supplied)

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Let’s start with a simple experiment. Take one toothpick from a pack of toothpicks and break it. Then try and break all of the rest of the toothpicks at once. Not so easy, is it? This illustrates the power of diversification.

In the investment world, diversification means the distribution of capital across different shares, investment vehicles and asset classes.

Many investors argue that the best way to beat inflation is to invest in property – while others insist that, if you are willing to wait long enough, shares are the only way to go. 

As someone who manages both share and unit trust portfolios, I am often asked which investment is best – buying shares directly, or investing via Funit trusts?

My answer is simple: there is a time and place for everything. It’s the same as asking golfer Louis Oosthuizen which club he’s going to use to play in the US Open. Every stroke is different, which is why he needs a whole range of clubs if he is to stand a chance of winning the tournament. 

Investing directly in shares provides a simple and versatile way to manage investments. The investor determines their own involvement in the management process by deciding how much discretion to give to the portfolio manager or stockbroker. 

Sales, as well as purchases, require investors to do their homework properly (whether you manage your portfolio yourself or have a manager to do it for you).

So, ultimately, investors are responsible for diversification. By contrast, a unit trust consists of a group of investors who pool their capital and invest it, and this is managed by a central fund manager.

The individual is only entitled to their portion of the whole and does not have a say in the management process.

Unit trusts come in a variety of forms, from money-market funds to equity-only portfolios, all of which can offer the benefits of diversification. But, just to be clear, in this article I am comparing equity unit trusts to the option of holding shares directly.  

The unit trust investor can invest either an initial lump sum, or make fixed monthly contributions. The benefit of unit trusts is that a lot of the individual investor’s homework is done by the fund manager, who is responsible for diversification within the fund. 

When considering whether to buy shares directly or opt for unit trusts, there are three main factors that investors must consider: 

1. Growth opportunities

Many investors will tell you that the three years up to 13 March 2018 weren’t a friendly share-investment environment, especially if we exclude Naspers* from the total growth achieved. But when we view share performance over a longer period, the picture changes quite a lot.

Over a period of five years, you would have beaten inflation by 6% per annum if you had invested in the FTSE/JSE All Share Index (Alsi), which grew by 11.13% a year.

Even when taking one of the biggest corrections of all time into consideration (2008), you would still have beaten inflation by 4.5% annually if you had invested in local shares (total return of 10.2% a year).

In comparison, with equity unit trusts, things weren’t exactly smooth sailing for fund managers either. Over the same three-year period, only three of the 138 general equity unit trusts managed to outperform the FTSE/JSE Alsi.

Furthermore, one of these three funds was a passive exchange-traded fund (ETF). 

Yet again, when we look back a bit further, you will see that if you took a gamble on the five largest general equity unit trust funds, three of these five funds managed to outperform the market and delivered an annual return of 11% a year. 

2. Costs

Unfortunately, it isn’t as simple as throwing dice. It takes years of expertise and continuous homework to get it right.

The current average total expense ratio (TER) for general equity unit trusts, is 1.37% per annum. However, these fees can vary, ranging from 0.21% a year to as much as 3.51%. So be careful.   

3. Risk

This brings me back to the beginning. Diversification helps to reduce risk. To have only one share in your portfolio is riskier than having two.

Unit trusts provide sufficient diversification to investors who have as little as R5 000 (and in some cases even less) to invest.

Ultimately, however, it boils down to where you can get the best value for the least amount of money and risk, regardless of whether you invest in shares or in unit trusts.

*finweek is a publication of Media24, a subsidiary of Naspers.

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 29 March edition of finweek. Buy and download the magazine here, or sign up for our weekly newsletter here.

unit trusts  |  investment  |  shares  |  diversification  |  stocks
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