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Diversification is the key to low-volatility returns

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Most of us learned not to put all of our eggs in one basket at our grandparents' knees.  The image of the eggs and the baskets is homespun, but it is a wonderful illustration of the benefits of diversification. Diversification has been described as the one free lunch in investment. It helps investors control risk in their portfolio, while maximising their returns.

In investments, diversification is achieved by investing across a range of unrelated or 'uncorrelated' asset classes, such as shares, bonds, property credit or cash.  Diversification can then be enhanced by taking multiple positions within each asset class.  Undertaking diversification can lower the risk across your portfolio because if one investment or sector underperforms, it will be isolated to just one part of your portfolio.

The importance of diversification has been highlighted over the last 12 months. The coronavirus triggered a period of intense market disruption. Asset values plummeted, particularly in listed markets, and individual sectors have since rebounded - some more than others. Amidst such volatility, diversification stands alone as a key mechanism to help control performance and deliver targeted results across an entire portfolio.

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In the current low-rate environment, locating low-volatility income has never been more important.  Within this hunt for yield, managed funds are outstanding vehicles to generate income while enjoying the benefits of greater diversification.  Managed funds allow a single point of entry to an asset class or strategy, and importantly enhance overall portfolio diversification.

When considering a managed fund it is important to ensure that the fund strategy aligns with your objectives.  Each managed fund will operate with a particular investment strategy, making fund manager selection critical to the resulting diversification.  For example, selecting a managed fund to provide diversification in a portfolio already weighted to the share market will not add value if the underlying fund manager's strategy is similar share market exposure.

Once comfortable with a particular fund manager and their investment strategy, it is important to ensure the fund manager also undertakes sufficient diversification.  Or more simply put, that the fund manager does not have all of their eggs in one basket either.  A manager with a strong emphasis on diversification will be better placed to execute on a chosen strategy than a manager with a concentrated asset base.

A further consideration for investors after satisfying themselves with the strategy and assets of the fund manager is to consider the level of disclosures and reporting available for public view.  This is often overlooked but remains a critical test of a fund manager's dedication to excellence.  A manager with confidence in their strategy and their position in the market should give a full and transparent view of their asset allocations, portfolio diversity and performance over any given timeframe.  Any reluctance to disclose key fund data should sound warning bells for potential investors.

The continued hunt for diversified sources of low volatility income will be a key driver of investment strategies in the years ahead, and a properly diversified portfolio provides the best opportunity for success.   With investors likely to continue diversifying into managed fund strategies to achieve their investment outcomes, it is critical that the underlying strategies themselves are duly diversified.  After all, if you are taking the sensible step of not putting all your eggs in one basket, shouldn't your fund manager too?

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Troy Stratton is deputy chief investment officer at La Trobe Financial. He has more than 20 years' experience in the financial services industry. Prior to joining La Trobe Financial, he worked in London in a number of leadership roles at Barclays Wealth and HSBC's Retail and Wealth Management divisions. Troy is also a certified accountant and holds a Bachelor of Business and a Bachelor of Computing degree.