From portfolios of stocks to portfolios of funds

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Over the last 20 years, one of the biggest trends I think we’ve seen during my career is the fundamental quantum unit of the portfolio shift from being stocks (usually domestic) to funds (global). This is true for large, institutional investors but it’s also true for individuals.

As just one example of this, UK individuals investing into the Nest growth fund (which data shows almost 10 million workers in the UK are invested in) have a portfolio of around 25 different funds.

This trend is perhaps best illustrated by this chart of US stock market ownership: you can see the proportion of stocks owned directly by individuals OR pension funds has fallen, replaced by mutual funds and more recently, ETFs (as well as international investors – which is also part of the trend I’m talking about).

Source: Goldman Sachs

It’s one of the biggest megathemes I’ve seen over my career. But is it always a good thing? Yes and no. There are some clear positives that come out of it, but some underappreciated downsides, including some subtle-but-real behavioral costs.

First let’s break this theme down into at least four sub-themes to understand how and why this shift occurred.

  1. Local to global

This was the first leg of this trend. Back in the early 2000’s when I started my career in investment consulting a common task was to help UK pension funds move from predominantly UK stock portfolios to global portfolios. Coming off the back of the rampant globalistion of the 1990’s and the early wave of digitisation this wasn’t surprising. A manager in London could now trade stocks listed in Sydney or New York with the click of a button, and companies were increasingly global in operations to the place of listing became less relevant, currency hedging was easy and cheap. There was a clear argument for diversification toward other markets, particularly when these markets (particularly the US) were deeper and arguably more innovative. This trend is also connected with the move toward passive – which favours funds over individual stock portfolios.

2. Benchmark focused to risk managed

As risk models developed and became commonplace a laser focus on investment risk developed which led toward managers launching funds that would define themeselves in terms of a certain level of risk expectation, rather than investing (say) in stocks and acccepting the level of risk that came along with that. More certainty on the risk front was clearly attractive to asset owners and consultants. Strategies such as Risk Parity and Diversified Growth Funds promised this.

3. Growth of liquid-alts & the “post hedge fund” era

The “lost decade” of stock market returns between 2000 and 2010 led to the growth in popularity of “alternatives” – strategies that were neither equity nor bonds and could earn returns in the sort of choppy sideways markets that typified that decade. The first iteration of this were your classic “2 and 20” type hedge funds in the early 2000’s, but this trend evolved as some of the sytematic drivers of the early strategies were pulled out into lower cost more transparent products, and later pressure caused by underperformance in the post-09 recovery brought fees down to more usual institutional levels. A new strategy segment was born spanning everything from trend following (“CTA”) hedge funds to factor-based risk premia to macro thematic absolute return strategies. Morningstar track 453 liquid alternatives funds that launched post-2009 across 7 strategies they track, of which only 153 survived.

More recently the growth in Exchange Traded Funds has

4 Private markets & bank disintermediation post 2008

Later came a wave of new types of fund, as managers packaged up strategies that were previously the preserve of only the largest and most specialist clients for the mass market, helped by a strong tailwind in the post-08 world of banks stepping back from many types of lending that launched a thousand private markets funds. Distressed debt, direct lending, loans, junior real-estate debt, asset-backed securities all became part of the fund universe. WE can see this trend in the growth of private markets in reports from McKinsey or Bain.

So, that being the history, what has it really meant for investors:

Reflecting on this trend there have been clear positives for investors, but also downsides which are less frequently appreciated.


Access to new assets & strategies: private markets, infrastructure, distressed debt, asset backed securities, high yield, loans to name a few. It’s hard to argue that choice is a bad thing, and some of these assets are genuinely differentiated and not available to a listed-market investor. Some of these strategies allow investors to tailor their return stream more toward income-type investments, which in an uncertain world and to an investor needing modest returns may well be preferable to the vagaries of markets. In a world where the public markets have become slightly less relevant, as the number of listed companies falls, and firms go public later in their journey or not at all, exposure to private markets is part of owning the full global portfolio.

Better global diversification, exposure to different sources of return. Going global vs domestic is a clear win here (especially for UK investors) which it is hard to argue against. And one thing almost any two investment professionals can agree on is the benefit of diversification.

But careful here, just because something is so universally agreed-upon as being good means it can easily run too far as a theme and I do think diversification is in danger of that. Research actually suggests that diversification is achieved at a much smaller number of positions than is often assumed, and many uncorrelated return drivers have proven to be either not-uncorrelated or not an actual long-term source of return. Sometimes, when we want something to be true we often accept it too unquestioningly. Could this lead to excessive conservatism, or over-diversification? More on this below.

Behavioral benefits. Making even small changes to our investing environment can have significant behavioral impacts which often go under-appreciated and are often negative. I do think that’s the case here (more below) but there are a couple of potentially positive behavioral improvements from owning a portfolio of funds.

Easier to sell losers early. Classically, a significant return drag we experience is selling winners too early and holding on to losers too long due to a fear of crystallising a loss and the requirement to effectively admit we were wrong in selling a loser. but having a portfolio of managers potentially allows us to project this a little onto the manager so that rather than admitting we were wrong, we have someone to blame: that stupid manager! In that world, perhaps it becomes easier to part ways with underperforming positions because we can blame the manager.

And the Negatives – often underappreciated

With a portfolio of funds you end up with vast numbers of underlying assets in a portfolio (easily thousands) – with incompatible data sources (eg public/private markets) could be thousands of underlying positions, you lose the ability to coherently analyse risk from different angles eg to spot concentrations to particular sectors , or appraise the exposure to inflation say or geographical spread.

You might say this ability is overrated anyway (more illusion-of-control than actual value add), and if the portfolio is well-diversified then in-the-round these individual sensitives won’t matter.

Fees can creep up. When it takes a decent amount of work to even calculate the total fees you are paying it’s always going to be hard to stay on top of this, especially when you have a dozen managers to monitor and speak to. New strategies being added are likely to have higher fees and without really good discipline at the overall level you may easily lose sight of the total charges being paid.

Forget to ask the question why. Why this fund, why this strategy. Or we might simply forget, or not have enough time to understand each strategy fully. With so many moving parts flying around it can be hard to stay on top of the reason why we have a fund in the portfolio. This can make it hard to hold on to when it goes through the inevitable underperformance as we may not be fully informed on the nature of the fund and what the expectations should be.

Excessive conservatism. A cautious approach to risk and downside risk management sells, and managers know this. But if you are slicing your portfolio up into 10% chunks then there’s really nothing wrong with having a couple of managers in there who aren’t holding back, who are fully embracing their best ideas, putting the “foot to the floor” and not trying to hedge. In fact if every fund in the portfolio starts building in downside hedges you probably get to a point where you are negatively impacting your returns. Excessive conservatism can easily creep in to a portfolio of funds.

Greater disintermediation between investors and investee companies – who is thinking like an owner? Stewardship often goes missing, sacrificed on the altar of risk adjusted returns you might say, as companies become numbers on a page within a fund (itself a number on a page within a portfolio).

When you are overseeing 10 or more different fund managers, asking about voting practices just isn’t a priority. So what? you might say, but I would argue this has resulted in the evolution of the industry in a strange way where there are so many layers of agency dis-intermediation between owner and asset that no-one is “thinking like an owner”. this OECD report investigates this exact issue. The move to funds (and passive) has concentrated ownership massively with less than 10 mega sized fund managers , who , reports show , have a track record of simply supporting the status quo in their voting behaviours.

Perhaps the biggest negatives here are on the behavioral front:

Action bias: More parts to a portfolio means more things to fiddle with and a greater chance we’ll make changes which is usually not a good thing. Like the goalie who always dives left or right trying to save a penalty when the better strategy is to stay still, as investors we love to fiddle when we should do nothing. Having 10+ funds in a portfolio there is always something not keeping up, something underperforming, so something to think about getting rid of or adding.

So, what can investors do to get the best of the positives of a move to a fund portfolio and avoid the negatives?

A lot of this comes down to being more intentional with focus:

Be disciplined on fees (know what they are)

Know why you own everything – take the time to go over this.

Set limits: minimum % of portfolio invested in a fund , maximum number of funds per asset class

Put in place behavioral measures to stop over-fiddling

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