Managed funds can fall into bank bias trap too

Investing via managed funds is commonly viewed as a way of boosting portfolio diversification, beyond holding direct shares alone, but even Australia's active managers can be prone to favouring sectors, says Morningstar’s Michael Malseed.

Australian financial services, in which our big four banks Westpac, Commonwealth Bank, NAB and ANZ Bank are over-represented, is a prominent example. Alongside the reputational damage from findings of misconduct during Kenneth Hayne's royal commission, they also face a slowing domestic economy and weakening east coast house prices.

Banks held up better than expected – Morningstar equity analyst David Ellis maintains a broadly positive long-term outlook and his wide-moat ratings – but investors must still consider their overall exposure to any single sector or theme when constructing portfolios.

"And given many retirees own banks directly, understanding the underlying exposure of fund investments is paramount," says Morningstar senior analyst, manager research, Michael Malseed in Morningstar's Australian Equities Sector Wrap 2018, released on 4 March.

Australia's big banks represent about 25 per cent of Australia's financial services sector.
Additionally, the broader financial services sector itself is over-represented in the S&P / ASX 200 benchmark index – accounting for about 33 per cent as at 31 December 2018.

"This exposure is almost double the weight of that same sector in the MSCI World Ex Australia Index – which is 17 per cent weighted to financials – and far outweighs most major developed indexes," says Malseed.

Table of financial services exposure by index

Source: Morningstar Direct

He says this remains the case, even after a meaningful decline in the sector globally over the past three years.

Malseed's research shows financial services sector exposure as high as 60 per cent and 52 per cent among two of the 11 index funds focused on providing investor distributions covered by Morningstar:

• SPDR MSCI Australia Sel Hi Div Yld ETF (SYI)
• Russell Inv High Dividend Aus Shares ETF (RDV)

"But even for broad-based active strategies, there is generally a very high weighting to the financial services sector," Malseed says.

Many active fund managers claim to be "benchmark-agnostic", but they're equally careful not to stray too far from the index, choosing to express their view on sectors in relation to the benchmark. They do this by being either underweight or overweight, perhaps taking a 22 per cent exposure to the S&P / ASX 200 index instead of holding the full 25 per cent exposure.

"Fund managers don't think in absolute terms, they think in relative terms," Malseed says.

The following managers have the top three overweight exposures to the index:

• Nikko AM Australian Share Concentrated (19895) - 38.8 per cent
• Franklin Templeton Australian Equity Wholesale (19308) - 38.19 per cent
• Nikko AM Australian Share Wholesale (3987) - 37.71.

Alternatively, he points to other products that position themselves to minimise this concentration risk.

The Blackrock Concentrated Industrial (41329), which holds a Morningstar Bronze medal, strips out the banks from its portfolio by avoiding the top five market-cap companies on the ASX.

Bennelong Ex-20 Australian Equities (17595), a Silver medal-rated fund, is another example in a similar vein.

Malseed's research finds only six strategies held less than 20 per cent of their portfolio in financial services: "they are typically high-conviction managers that pay little heed to benchmark weights".

Managers with less than 20% in financial services

Source: Morningstar Direct

"Whether or not market concerns have been overplayed in the financial services sector, investors should be aware of the overall level of sector exposure borne by their portfolios," says Malseed.

"Investors should always be aware of the level of unintended risk within their portfolios through concentration risk, and we advocate for portfolio diversification across asset classes, geographies, and sectors."