How to pair active funds to get true diversification

Diversification in an investment portfolio comes in many forms.

It can be achieved through different types of assets, like shares and bonds. It can be geographic, through investments in different corners of the world. And if you’re focusing on investing in shares, diversification can also come through style.

Just as some countries will perform better than others at times, the same is true of styles. Growth and value styles will come in and out of fashion depending on broader market and economic conditions.

This article isn’t personal advice. All investments and any income from them can rise and fall in value, so you could get back less than you invest. Past performance isn’t a guide to the future. If you’re not sure an investment is right for you, ask for financial advice.

What’s growth and value investing?

Growth investing focuses on companies that are expected to grow earnings faster than others. This could be due to development of a new product or a dominant position in its market.

Value investors look for shares in companies at a price less than their true worth. It might be that a company has missed a target, or that the sector in which the company operates is currently out of favour. The idea is that once things improve, the share price will rise.

These two styles typically perform differently under different conditions.

For example, value companies tend to perform better when the economy is weaker or soon after a recession when the economy is improving. These companies can be more mature, and some have more stable earnings if they are well established, so tend to be less affected when consumer spending falls. Financials and utilities fit this definition well. That said, highly economically sensitive businesses might struggle in the depths of an economic crisis.

On the other hand, growth companies might perform better when interest rates are lower. It’s cheaper for them to borrow money to finance research & development or expand to new markets. This part of the market typically contains more technology companies.

What impact can style have?

A good example of a stylised market, where there can be a noticeable difference between growth and value, is Japan.

The chart below shows the performance over the past ten years of the two Japan funds on our Wealth Shortlist, compared to the average returns of the IA Japan peer group. Both funds have a distinct style bias, with Man Japan CoreAlpha favouring value and Baillie Gifford Japanese favouring growth.

When the line for a fund is moving upwards, it means it’s outperforming the IA Japan sector. When it’s going down, it’s underperforming. Note that each fund has grown over time, but the point is they perform well at different times, offering true diversification.

While value investing has outperformed growth for much of the past five years, growth was far stronger in the five years before. As always, past performance isn’t a guide to the future.

The benefits of stock-picking

One way to invest without being exposed to different styles is to invest in a tracker fund. These aim to track the performance of a particular market by investing in most, if not all, of the companies in that market. Tracker funds also offer a low-cost way to invest.

Active funds instead try to perform better than a stock market by actively picking individual stocks.

Active funds with a distinct style will naturally go through periods of underperformance when their style is out of favour. But they still have the ability to add value through stock selection – investing in companies that go on to perform well regardless of their country, sector, or style – particularly over longer periods.

Fund pairings to balance style

Here are three pairs of growth and value funds from our Wealth Shortlist we think could pair well as part of a diversified investment portfolio.

Investing in these funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest and make sure any new investment forms part of a long-term diversified portfolio.