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Diversification In-Depth
Thinking Inside the Box
 By Tim Hicks
Portfolio Manager
Russell Investments Canada Limited
While thinking outside the box has become a catchphrase in recent years, at Russell, we believe it's equally important to think creatively and perceptively inside the box as well — the style box that is. This is especially true for investors who are concerned about diversification.
The nine-squared checkerboard has been popularized for mutual fund style categories that classify funds according to the types of securities they typically hold. For equity funds, there are two key factors: the average size of the companies in its portfolio and the average price it's willing to pay for a stock, as indicated by its average price/earnings and price/book ratios.
Style boxes are a useful way for investors to get a general idea of where a certain portfolio fits within the mutual-fund universe. Some investors go a step further and use the style box to root out redundancy in their fund choices. The idea seems to be that a portfolio is adequately diversified if it has one and only one fund for each style category — sort of like chocolates in a box.
Don't Fence Them In
 No doubt this notion has its limitations. True, it may not be feasible or cost-effective for investors with fairly modest portfolios to own more than one fund in each category (if that). Other investors, however, may find that holding two or more portfolios in the same style box can yield significant diversification benefits.
Canadian equity funds managed by Russell feature two managers who both cover the broad universe of small cap stocks. Guardian Capital and Cypress Capital Management both focus on selecting stocks that are not the big names that comprise most of the weight in the TSE 300 Index. On the surface, their portfolios may seem similar to the casual observer: They select stocks from the universe of names not in the top 100 companies in the TSE 300. They both look for reasonable growth at what they consider to be reasonable valuations. Both managers prefer companies with a track record and favour ones with a history of growing sales and earnings. The companies they hold tend to have a higher than average return on equity. As a result, both managers are categorised as small-cap. Yet each of them brings something different to the table, and it takes a closer look to see why.
Same Universe, Different Strategies
Guardian is more price sensitive than Cypress. They are more likely to sell a winner early, when a stock's valuation moves beyond their comfort level. As a result, they sometimes exit a stock early in an explosive situation such as was experienced with high techs in 1999 and 2000. On the other hand, they tend to avoid the "boom and bust" situation where a manager can ride a stock all the way up to a peak and then ride it all the way down again if there is an earnings disappointment.
Cypress is more willing to "let winners run" as long as they are convinced the company has staying power and will execute on its strategies. Cypress is also more willing to buy a stock earlier in its life, and as a result, they tend to hold smaller companies than Guardian.
A Look Under the Microscope
The differences between Guardian's and Cypress' strategies are really apparent only from a close comparison of their portfolios. Cypress' focus on the smaller names in the small-cap universe means that it is willing to pay somewhat higher valuations than Guardian is. This is partially driven by the fact that smaller companies often have low current earnings but higher earnings expectations. It is also driven by Cypress' willingness to stick with what they believe is a good story for longer.
These differences manifest themselves in other ways. For example, Cypress generally believes that resource companies offer low potential for sustained long-term growth. Their feeling is that the fortunes of these companies are largely tied to the price of the commodity they produce. They therefore tend to de-emphasise this area. This causes them to construct portfolios that have quite different sector weights than the TSE 200 benchmark relative to Guardian. This leads to greater variability of their performance relative to the benchmark.
Manager Size is Important
A statistic often missing from ratings reports is the amount of assets a manager is currently investing in a particular strategy. This is an important consideration for a small cap manager. Guardian is a larger manager with significant small cap assets from a variety of clients. In order to construct diversified portfolios for all their clients, they will tend to hold a portfolio of 50-60 stocks.
Cypress manages fewer assets and is able and willing to concentrate its positions more than Guardian. They will typically hold 30-40 stocks. This leads to more stock-specific risk and more volatility, but potentially higher returns.
The Complete View
 The upshot? Given the differences between Guardian's and Cypress' investment processes, there's room for both of these strategies in Russell's Canadian equity funds. Unfortunately, most individual investors simply don't have the tools, the time or the access to discern these differences. While basic tools such as style boxes can give you a good start, there's a lot they can't tell you.
Russell takes a much closer look, which is why we're dedicated to analysing investment managers so exhaustively. Russell's research and analytical depth allow us to understand the true character of managers over time. As a result, we have a more complete view of their strategies and can leverage those insights in the portfolios we construct for our clients. And that, we believe, is really "thinking outside the box."
For more on Russell's multi-style and multi-manager processes, see the Multi Style and Multi Manager sections of the Russell Investment Approach.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Money market mutual fund securities are not covered by the Canadian Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that a money market funds will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment will be returned to you.
Diversification does not assure a profit or guarantee against loss in declining markets.
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