Fund managers should not glorify diversification, says expert

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One important reason why fund managers as a group do not add value for their clients is that diversification dilutes their stock selection skills. These are some of the findings that Professor Ron Bird, Director of the Paul Woolley Centre, will discuss at the Australian Centre for Financial Studies next week.

The four studies, which have been conducted over the last three years by the Paul Woolley Centre, focus specifically on behaviour within fund management firms and how they translate into performance for clients.

Professor Bird says: “The good news is that fund managers do have good stock selection skills, but after selecting their key stocks they tend to diversify their portfolios with stocks that dilute performance. We often glorify diversification but fund managers should hold stocks that they are confidant about and not be obsessed about building a diversified strategy.”

He quotes Warren Buffett who once said “Diversification is protection against ignorance.”

“In our second study, we looked at how fund managers behave through their corporate lifecycle. They often start as a small fund, and are aggressive, and hold large positions. But as they get bigger and manage more money, they tend to become less aggressive and tend to protect their positions. They become more like index funds to the possible detriment of their clients. “What our studies clearly show is that fund management successes are often determined by chance, rather than skills. So the clear message for investors is that they should stay away from large fund mangers and look for managers that believe in
concentrated investments.

“Investors should diversify their investments amongst small managers and should know when to change their managers. So rather than holding one big diversified portfolio, they should look at several small, concentrated portfolios.

“Our studies show that value as an investment style does outperform. However, investors need to exercise caution as when value managers try to outperform they take value away from their portfolios.

“So who is a really good fund manager? We haven’t got much evidence to tell us who are the good managers and who are bad, as performance is based on chance. It’s an industry governed by chance. So we need to look at behavioural traits. Evidence strongly supports that managers who behave as though they are above-average, achieve the best performance.”

Professor Bird will be presenting key findings of these four studies in detail on 20 May 2014 at ACFS/FINSIA, Melbourne.

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