Don’t let your RAs disguise over-diversification

Dust off your retirement annuities (RAs), scrape away the wrapper and take a long look at the underlying investments. You may find yourself staring at costly over-diversification you could easily do without.

The consumer advice comes from Imara Asset Management South Africa, a wealth company and advisory services provider that frequently “unpacks” portfolios for clients hoping to achieve greater cost efficiency from investment and retirement products that have been accumulated over decades.

“Over-diversification can reduce returns while paying the higher costs of active management,” says Lara Warburton, managing director. “It’s particularly important to scrutinise the investments driving the performance of preservation funds and RAs.

“A consumer might be paying for levels of equity diversification that are unnecessary from a risk management and portfolio balance perspective.

“This often happens with RAs as several might be acquired down the years while investors have only a vague idea about the funds they’ve bought into.”

To illustrate the challenge, Warburton pointed to a hypothetical case in which a client took out three RAs from different product providers, with the inflow into each RA spread across five funds or 15 unit trusts in all.

The 15 managers are paid for active management, with the danger that the shares sold one day by one manager will be bought the next by another manager at a different fund.

Transaction costs are picked up by the investor, whose net underlying position remains the same.

Furthermore, multiple fund managers trading across a limited marketplace will tend over time to deliver index-type returns rather than active management outperformance.

Active managers charge more for striving to beat rather than mirror the market. Passive, index-tracker products are cheaper.

“There are only about 180 actively traded stocks in South Africa,” says Warburton. “If you have hired 15 fund managers, they will almost certainly buy and sell across this ‘universe’.

“Over-diversification like this creates the risk you will end up tracking the market for average returns that might have been delivered by more affordable passive investments. Paying for active management multiplied by 15 is hardly cost efficient.”

When costly over-diversification is uncovered, one solution is RA consolidation.

“In pre-retirement planning,” says Warburton, “we encourage our clients to demand hard-working investments without clutter and without undue costs.

“Diversification has a role across asset classes and across geographies, but over-diversification within a single asset class like domestic equities has to be questioned. Often, consolidation can improve cost efficiency without adverse effects.”

Regulatory changes mean punitive penalties no longer apply when an RA is transferred to another firm before retirement. However, surrender fees may accrue.

Warburton adds: “Paying for over-diversification is hardly prudent, but professional advice from an experienced financial planner is necessary to ensure the portfolio is positioned for best investment returns given the risk profile of the investor. Every case must be judged on its merits.”

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