Whether it is growth over value or top-down over bottom-up, each strategy has both its advantages and disadvantages.
We asked two heavy-hitters in the industry why they stick to their process, no matter the market conditions.
Giles Hargreave and Simon Moon each manage one of the best-performing funds in the higher risk and often more volatile UK Smaller Companies sector, but they have completely different strategies.
They approach the diversification versus high-conviction argument from opposite viewpoints – here, they explain their thinking.
Hargreave: Don’t put all your eggs in one basket
FE Alpha Manager Giles Hargreave (pictured) holds 245 companies in his £652m Marlborough Special Situations fund. He says that he prefers to cut down his exposure to individual disappointments, but says this can only be achieved by having a big team behind him.
"Obviously, by holding an array of companies you are avoiding single-stock risk," Hargreave said. "Unexpected things happen to companies and certainly unexpected things happen to smaller companies. I mean, if you have a 5 per cent or 6 per cent holding in a company and it underperforms, it can have a pretty calamitous effect on your fund’s performance."
"However, of course if you are going to have a lot of stocks in your fund, then you are going to need a large amount of people in your team."
"The main reason why we have a lot of companies in our fund is to reduce risk and for diversification purposes, but we can only do it by having a lot of people in the team. All in all, we have 20 people," he added.
The manager has certainly limited his single-stock risk: his largest holding, the FTSE AIM-listed Advanced Computer Software Group, makes up just 1.4 per cent of assets under management.
Hargreave has run Marlborough Special Situations since July 1998 and he is widely regarded as one of the best UK small cap managers in the business.
The fund is a top-quartile performer in the IMA UK Smaller Companies sector over 10 years, with returns of 353.39 per cent, beating the average fund by 164.57 percentage points.
Performance of fund vs sector over 10yrs
Source: FE Analytics
Although the fund has beaten the sector over three and five years, it is second quartile over both of those time frames.
Hargreave’s diversified approach has helped him to defend his investors' capital more effectively in down markets. For example in 2008 the fund beat the sector but still lost 38.65 per cent. In 2011 Marlborough was top quartile, only losing 2.16 per cent while the average fund lost 9.04 per cent.
In the more recent rally, however, Marlborough Special Situations has lagged. It was bottom quartile in 2012 and is bottom quartile so far this year.
Marlborough Special Situations requires a minimum investment of £1,000 and has an ongoing charges figure (OCF) of 1.53 per cent.
Moon: Fewer is better
Simon Moon manages the Unicorn UK Smaller Companies fund with FE Alpha Manager John McClure.
In stark contrast to Hargreave’s fund, Moon and McClure hold just 30 companies within their £11.4m portfolio. He says this allows them to really back what they perceive to be the best companies available.
"It’s probably not a new idea, but by taking a high conviction you are benefiting from holding just your best ideas," Moon said.
"But the main benefit of holding a smaller number of stocks is familiarity. We can build up a close relationship with company management teams and we see the companies we hold twice a year; sometimes those will be on-site visits."
"I mean, if you were to invest in more than 100 companies, I really don’t think there is enough time in the day to keep on top of them."
"It also gives us a good insight into the market by holding a smaller number of stocks to our peers. If we can find a decently valued company whose share price has fallen on basically no news, then we can pick it up easily."
"Also, by relying on just a few companies, each one has to justify its inclusion. It’s like with a football squad, a manager has to be confident that the player they are bringing in is better than the selection he already has," he added.
Moon and McClure’s largest holding is Liontrust Asset Management, which makes up 5.9 per cent of the fund. However, although they own just 30 companies, the fund’s assets are still reasonably spread out, with the top-10 holdings accounting for just over 40 per cent of the portfolio.
Unicorn UK Smaller Companies has struggled over the long-term and is a bottom-quartile performer over 10 years. One of the main reasons for this is its negative returns in 2004, losing 2.65 per cent while the average fund in the sector made more than 20 per cent.
However, the fund is a top-quartile performer over five years with returns of 123.38 per cent, comfortably outperforming its Numis Smaller Companies ex IT benchmark in the process.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
The fund performed better than Marlborough Special Sits in the crisis year of 2008. It did not bounce back as strongly as the overall UK small cap market in 2009, although it still returned 39.85 per cent that year.
Unicorn UK Smaller Companies, like Hargreave's fund, was bottom quartile last year but is a top-quartile performer so far in 2013.
Like with any strategy, Moon says that there are some negatives to owning a smaller amount compared with his competitors.
"It is quite interesting as the largest negative of having a small portfolio is that it is associated with being very high conviction, so we are exposed to stock-specific risk," Moon explained.
Moon says that another disadvantage to investing in a smaller number of holdings is that the fund cannot absorb inflows as easily as some of its larger peers.
The manager also acknowledges that having a close relationship with company management teams means he can fall into the trap of falling in love with a business. However, he says that he and McClure do not make this mistake.
"We are very conscious of that and we are not scared to get rid of a stock if it has failed expectations or is underperforming. Even if we have a good relationship with the management team, we don’t hesitate to bin it if we need to."
"Each company must justify its existence in the fund," Moon added.
Unicorn UK Smaller Companies requires a minimum investment of £2,500 and has a total expense ratio (TER) of 1.79 per cent.
