We all understand that diversification is important within a portfolio and that spreading investments can mitigate risk. However, there are times when diversification is a cop out and actually an overly-diversified portfolio becomes detrimental.
My point, naturally, relates specifically to the tax-efficient investment space in which my team operates. I recently spoke with an experienced adviser who had historically done little in the EIS or Business Relief space but had recently had a specific client need and had utilised a product with somewhere around 50 individual companies within the portfolio. He was concerned that the performance of the overall portfolio was pretty much flat lining (it wasn’t even that good but let’s be optimistic). When we spoke he was intrigued that in our EIS portfolios we only ever have a maximum of six companies and in our SEIS propositions ten.
His immediate reaction was that this was not diversified enough for him and he wanted to spread the risk. On further discussion, I explained our position that playing the numbers game certainly works with mainstream investments in large listed stocks; however with small companies the most crucial factor to mitigate risk is to understand and actively manage the underlying investment companies.
Diversification is important, which is why we don’t offer single-company investments to retail clients, but over-diversification drastically reduces the input we could provide to a firm. Not only does this prevent active management but it also limits the shareholder protection and rights of the investor within those companies – often limiting the upside for investors as a successful company will likely dilute investor shareholdings as it grows. By taking an active management in the underlying company, we are able to limit the effects of dilution and look after our investor’s interests.
My attitude to this type of investment is that understanding the underlying investment is crucial to mitigating risk and maximising any potential growth. Therefore, over-diversification should ring alarm bells for investors and advisers. The underlying investments should be credible investments in their own right – any potential tax benefits should be seen as a bonus.
Understanding the approach of the investment manager is vitally important and advisers should identify what type of manager is right for their clients and themselves. For example, I know a number of advisers who like being able to discuss with clients exactly where their investment will be going and tell them about the companies within a portfolio – also having the opportunity to meet the investee companies is enjoyed. Over diversification makes this almost impossible.
Investing in small and growing UK companies is not just a balance sheet or share price judgement. Over diversification limits the opportunity to have a real say in how an investee company is being run and, in my opinion, exposes the investor to unnecessary risk and the greater exposure to market forces.
Ian Warwick is managing director at Deepbridge Advisers.