Risk is probably the subject you will spend the most time on when discussing your investment portfolio with your financial planner, particularly if you are considering adopting a new strategy or investment product for the first time. This is entirely appropriate. The amount of risk you are willing and able to take is a key driver of the investment decision-making process.
It is crucial, however, to make sure that the conversation about risk focuses on the areas that are relevant and that the risks inherent in an investment proposition are properly understood.
One area that we often receive questions on is concentration risk. This is the principle of ‘putting all your eggs in one basket’.
A portfolio with a large proportion of its assets in a single type of investment, or a group of investments with similar characteristics, has higher concentration risk. This is why we always recommend diversification.
Sometimes clients look at the funds held in our models and question, given this principle, why we allocate a large proportion of the portfolio to a single fund manager.
They tend to have two main concerns:
1. “If the fund manager gets something wrong, it would impact a significant portion of my portfolio.”
These funds are all index trackers. This means that the investment manager does not have autonomy in selecting which stocks and shares to buy within the fund.
In the case of equity funds, fund managers buy all the stocks in the market index in the proportions that they are represented in the market. For fixed income portfolios they do the same, unless it is not practically possible, in which case they select those stocks that represent the whole market as closely as they can.
The process is mechanical (hence why it has such low management fees) so investing in a high number of funds with one fund manager does not create a larger chance that the portfolio is disadvantaged by them not being good at choosing stocks. They don’t get to choose them.
Our due diligence research shows that the fund managers in our recommended portfolios have consistently achieved good results in index tracking and have robust systems in place to enable them to repeat this. Should our ongoing monitoring reveal that this skill is deteriorating or are no longer competitive on price, we would not hesitate to re-allocate to a superior provider.
As an interesting aside, overall, our portfolios have 11,281 holdings in total (as at end September 2016), providing full diversification.
2. “If the fund manager were to experience financial problems, a significant portion of my investment portfolio would be at risk.”
The Global Financial Crisis in 2008 has heightened awareness of the risks clients face when placing their investments with financial institutions. There are often concerns that, should an organisation experience its own financial difficulty, investors could lose their savings.
Investments in collective funds such as OEICS and Unit Trusts do not expose investors to the provider in the same way that cash accounts do. The fund manager does not have custody of the underlying assets in each fund, these are all held at an independent third party. This is a regulatory requirement.
The third party ring fences your assets from those of the fund manager and oversees how they are managed. For example, the fund manager makes investment decisions and instructs trades to the market, the custodian settles those trades, taking receipt of or delivering stocks and moving cash as required.
This means that should the fund manager experience any financial difficulties of their own, your assets are protected. If the fund manager were to default for example, the underlying investments would remain intact.