President and CEO of IBV Capital says many modern portfolios suffer from return dilution
Spreading your portfolio too thinly can lead investors into the realm of “diworsification” according to the president and CEO of IBV Capital.
Talbot Babineau said the strategy of having more focused and concentrated assets is at the core of his company’s approach. In many ways, though, this flies in the face of modern portfolio theory, which suggests investors should be exceptionally well spread and that, as the saying goes, “the only free lunch is diversification”.
He told WP: “I think when you look at many of the portfolios today, it’s very challenging to understand what the 762nd investment brings to the table. Being cognizant of that, once you try to articulate why that investment is necessary, it becomes far more challenging, which begs the question: why is it there?”
Babineau said the theory of being diversified to the hilt is not necessarily beneficial to somebody’s holistic allocation strategy. In his quarterly report letter to investors, he explained that when a diversified asset allocation strategy is put into effect, IBV found that investors prefered to allocate only a small portion of their portfolio to any one fund, with the frequently mentioned allocation figure of 2.5%.
He added that using this approach and weighting across an asset allocation strategy, it therefore translates into having a portfolio of 40 different fund exposures. He added that 40 funds with 20-40 positions each equates to having between 800 and 1,600 investments, and a portfolio weighting of 0.06% to 0.13% for each security, assuming there are no duplications.
Babineau believes this hypothetical portfolio suffers from return dilution, meaning that applying a modest weighting to great investment ideas will suppress their impact on overall performance.
He said: “We put fewer eggs into our basket and watch that basket really, really closely. In terms of what it does for returns, we have a more concentrated portfolio so when we’re right on particular investment idea it has a much larger impact on our return profiles.
“It adds a level of discipline to the investing process that might not occur if you put 10 basis points of your portfolio into one thing and then 10 basis points into something else. If you lose that 10 basis points, it’s not going to have a material impact so what ends up happening is you don’t intensely look at anything, which I don’t think prompts good behaviour.”
Babineau said this approach requires an emotional component that is underappreciated because most people’s instinct when the market starts going down is to run away, sell their assets and get out.
He said: “We take an almost exact opposite approach. That takes a very specific temperament and a heightened level of confidence in your underlying research to be able to transact when people are most fearful.
“The perfect example was the fourth quarter of 2011 when Greece was leaving the EU. CDS spreads were back at 2009 levels and the Bank of America was trading at $6 a share but we were very aggressively investing. At that point in time it was trading at a fraction of book of value and common convention on the street was that it was uninvestable.”