The numbers game

Regular readers of Investors Chronicle's 'portfolio clinic' section will be familiar with a common recommendation to those who've submitted their personal investments for expert analysis: "you're holding too many funds".

It can be tricky for retail investors to strike the right balance (another regular tip from the clinic is, admittedly, "you need to diversify"). DFMs, in theory, should be better at doing so.

In practice, opinion is split on precisely the optimum way to go about things. The chart below, setting out the number of holdings in a range of Balanced model portfolios in our database, illustrates that nicely.

Sometimes it's simply a question of how much money a client has. The most basic models tend to use a small number of funds as building blocks, whereas the more advanced iterations tend to diversify a little more.

That flips right at the bottom end of the scale: we shouldn't forget that unitised solutions, which typically serve the lowest-value clients, are often to be packed to the rafters with far more funds than any model.

Our chart focuses on models, and indicates that the average number of fund holdings is around the 20/22 mark. But there are outliers, particularly at the higher end of the scale - for a couple of providers it's almost a case of the more the merrier.

Equally interesting is the way these portfolios are divided up. When it comes to number of choices, there's a definite equity bias. MPS tend to hold a variety of equity funds across a range of asset classes, but settle for just a handful of bond and alternatives positions to offset this exposure. 

Partly that's a factor of overall weightings - shares will take up the bulk of most risk models. But it's also because DFMs are more inclined to use bond funds (and occasionally alternatives) as "building blocks", with each individual position occupying a larger chunk of the overall portfolio.

Correlations: a moveable feast

However funds are combined, the most important aspect of diversification is to make sure underlying products aren't all moving in the same direction. Investing 101 tells us that correlations aren't static. 

We saw some suggestion of that early last week, though the theory that the FTSE 100 has less of an inverse correlation to sterling than it once did wasn't entirely borne out by the events of Thursday onwards.

Evidence that other parts of the market are moving in unusual ways is no easier to verify. But one (very) broad approximation is to look at the interactions of various IA sectors with one another. 

These comparisons can provide useful theories to investigate further - hinting at the extent to which strategic bond fund performance is inextricably linked to the high-yield debt such funds hold, for example. As it happens, FE data shows the correlation between the two sectors has dropped to 0.65 on a 12-month view.

Short-term these scenarios may be, but they can provide early signs that tried and tested patterns are breaking down, or firming up. Take the absolute return sector, which remains more closely correlated with a variety of equity sectors than wealth managers might hope. We're talking 12-month correlations of 0.7 or above in most cases, according to FE.

AR funds do a better job of distinguishing themselves from bonds - though whether this is the desired outcome is debatable, given many tout themselves as a replacement for fixed income exposure. In any case, that's partly a function of how bonds themselves have performed over the past year. 

The data suggests UK gilts and index-linked gilt funds have decoupled from the rest of the fund universe over that timeframe. A Brexit effect or something more complicated? The 60/40 portfolio may be dead, but domestic equities and bonds have yet to move in tandem in the way most critics have feared.

Chips are down

Investors were back to familiar woes overnight as the Faang names endured a fresh bout of selling. Not exactly welcome news for many portfolios. But at least it won't come as a huge shock, given many of the (suspected) factors behind last month's market drops have shown little sign of giving way.

One reason that it is different this time is the enhanced level of attention dedicated to chipmakers, whose shares have followed the Faang names downward in recent sessions. That's not to say they were spared during last month's volatility, but concerns have been raised about the prospect of a longer-term decline.

There are a number of reasons behind the sector's recent mini-meltdown, from continuing trade tensions to a slump in cryptocurrency values. The saga also reminds investors how interconnected sub-sectors can be.

Beyond that, the plight of these names reiterates one lesson the BAT stocks have recently taught us: that the downfall of frothy tech names can be as much an EM story as a US one.

Those searching for evidence need only look at an EM investor favourite, Taiwan Semiconductor Manufacturing Company, which has been caught up in recent selling. Of the most popular 10 EM funds in our MPS tracker, half have at least 5 per cent of assets tied up in the firm. DFMs who want to reassess their tech positions - whether by taking profits or buying a dip - should take heed.