Jennifer Radman is the Portfolio Manager of the Caldwell Canadian Value Momentum Fund and shares her thoughts with us regarding diversification.

Mediaplanet: What is diversification?

Jennifer Radman: Diversification is a risk management tool used in constructing investment portfolios. Since different asset classes, geographies, business sectors, and even companies have different underlying factors that affect their performance, each investment’s returns will follow a different path. When one investment zigs, the other often zags.

MP: Why is diversification important?

JR: The goal of investing is to own investments that will grow in value over time. However, we all know that investments don’t rise in a straight line. When you open your monthly statement, the value of your portfolio may be up in some periods and down in others. By diversifying a portfolio using different investments that move differently, the goal is to create a portfolio that produces less month-to-month volatility, than each investment on its own, without compromising overall returns. In financial jargon, diversification produces higher risk-adjusted returns.

MP: Have you ever seen evidence of poor diversification?

JR: We’re going to focus on stocks, given other asset classes are still in the early stages of being broadly available to individual investors. A lack of diversification is relatively easy to detect. Clients will come to us owning a single stock or a portfolio full of energy and mining stocks. You need more than one stock to safely grow your wealth over time and the commodity industry is highly cyclical.

MP: Is it possible to over-diversify?

JR: Absolutely! It’s actually a big problem in Canada, possibly because it’s less obvious for investors to detect. Too many stocks means good things at some companies are completely offset by bad things at other companies. The result is that your portfolio ends up behaving like the index.

The Canadian market in 2015 provides a great example. The S&P/TSX Composite Total Return Index lost over 8 percent that year. The average Canadian equity fund’s correlation to the Index rose to 0.98 so that the average Canadian equity fund lost more than 6 percent.

MP: How can investors protect themselves from over-diversification?

JR: We recommend a portfolio of 15-30 stocks for optimal diversification. Investors should also seek out high active share scores (75 percent or more) and low correlations across investments (less than 0.7).  Active share is a statistic that shows how differently your portfolio is being managed versus the index while low correlations indicate better diversification.
Unfortunately, most mutual funds in Canada show poorly on these scores. The average mutual fund in Canada owns roughly 59 stocks. Looking at the Canadian equity category, the average five-year correlation is 0.89, meaning that 79 percent of performance is driven by the underlying index.

1Lastly, a study found that 37 percent of mutual funds in Canada have a sub-60 active share score.

2This translates into an extremely large amount of Canadian investors’ money that’s being sub-optimally managed.

A word of caution to those thinking this doesn’t affect them because they own individual stocks over funds: many large investment firms (and their investment advisors) work off of model portfolios. The amount of money they’re investing is so massive that you essentially own what everyone else does.

Your investment advisor should be able to provide all of the above information on your portfolio. If not, we’re happy to help.     

MP: Can the Caldwell Canadian Value Momentum Fund (CCVMF) help diversify my portfolio?

JR: Yes! The CCVMF targets 15-25 stocks exhibiting strong growth catalysts. At the highest level, it aims to own the best companies in Canada, at the best time. It has peer leading active share and five-year correlation (98 percent and 0.62, respectively) which has allowed the CCVMF to significantly outperform the S&P/TSX Composite Index.3  Importantly, it is one of only five Canadian equity funds to have posted a positive return in the difficult 2015 market.