Beware of over-diversification

‘If you’ve going to put together a portfolio, try to keep it quite narrow,’ says Sanlam’s Nick Kunze.

RYK VAN NIEKERK: Welcome to this week’s edition of the Be a Better Investor podcast. It is the podcast where I pick the brains of the top professional investors in the country, and we delve into their own personal investment approaches. We talk about the research process they follow to identify potential investments. We also talk about their best and worst investments ever, and the idea is to find those golden nuggets of wisdom to assist amateur retail investors to become better investors.

My guest today is Nick Kunze. He is currently a portfolio manager at Sanlam Private Wealth, but he really has a wealth of experience. He has been in the industry for more than 25 years and he has extensive experience in the management of equity portfolios, derivative trading, alternative investments and statistical arbitrage.

Nick, thank you so much for joining me. I know arbitrage is the process where you exploit the mispricing of the same asset in different markets, but what is statistical arbitrage?

NICK KUNZE: Yeah, that intro made me feel old, but anyway [chuckling]. Statistical arbitrage is quite a fancy name like most of us [use] in the financial markets to make it a bit more complicated than it actually is. But you are right on the definition of arbitrage – you take advantage of price differentials and you take the difference between the two. You buy one, the expensive one, you sell the other. Statistical arbitrage, or ‘stat arb’ as the hedgies like to call it, is when you would take an index, say for example, you take the JSE Top 40, it’s a tradable index. You can buy the Alsi futures and you take the basket of the shares. The idea is you trade the sort of basket of options on each – stop me if  I’m getting a little bit too complicated – an individual share we all know moves a lot more than, say, an index.

And we saw, for example, the last few days you had, Sasol moving 5% or AngloGold moving 10% on a good day. Like yesterday the gold shares moved so much, but yet our overall index only moved about less than 1%, so it hardly budged. So there’s your arb right there, Ryk, because what you do is you would actually sell the volatility on the index which is not moving. So you sell it because it doesn’t do anything, and then you’d buy the actual, what they call the volatility on the basket of shares because they move much more. So you’re making money on the ones that move and you’re basically willing to sell something that doesn’t move. So that’s it in a very simple nutshell.

RYK VAN NIEKERK: Derivatives have emerged and grown a lot in South Africa since the late nineties, when we saw the first – what were they called?

NICK KUNZE: Warrants.

RYK VAN NIEKERK: The warrants, yes.

NICK KUNZE: Then came the CFDs shortly afterwards. Yes.

RYK VAN NIEKERK: How big is that market currently, especially among retail investors?

NICK KUNZE: It’s pretty much non-existent now. These markets sort of blow hot and cold, I think, and they come into favour and they go out of favour. I think back in the day the investment banks that were making the markets and a lot of the warrants, which got people first interested in it, I honestly think [then] a lot of people didn’t do their homework, so what the investment banks and the market makers were doing was mispricing those warrants; they were [more] expensive than they should have been. Retail investors were overpaying for [them], and a lot of that market got, at the end of the day, basically got what they call sort of ‘traded out’.

Those don’t exist just too much anymore. But there’s still a very healthy derivative market in the background in South Africa. Whether it be single-stock futures or Alsi futures, I believe that is still very active at the moment.

RYK VAN NIEKERK: Now of course you manage very large portfolios at Sanlam, but do you invest for yourself? Are you an avid personal investor?

NICK KUNZE: I like to keep my personal investing to the extent that my wife recently said, [you] don’t want to manage your money, and I said, ‘absolutely not’. It’s a sign of a healthy marriage, and I gave it to one of my colleagues to manage. But I actually don’t manage my own money, and I’ll tell you why. I did find over the years when we used to trade for clients a lot, when I was more on the trading front many years ago, I found it did become a little bit of a conflict of interest when you are sort of more active in the market and you’ve got clients on one side and you could be on the other side. So due to that sort of history, I’ve given it to other people to manage. So no, I don’t manage my own money. I give it to someone else to look after.

But it allows me actually, funnily enough, to be completely unemotional with someone else’s money. It’s a lot easier.

RYK VAN NIEKERK: That’s actually quite interesting. Do you maybe invest in other asset classes as opposed to equities, which seems to be your day job?

NICK KUNZE: I do, I do. My background, as you said in the intro, is more on the trading side. So I’ve sort of morphed into more long-term sort of money management, but I’ve still got a little bit of the history of the trading side. So I tend to look at any asset class it moves as investable. So whether it be bonds, whether it be equities, whether it be currencies I treat all these things, even volatility I would treat as an asset class as such. As long as it moves and I can get a price on it, I think it’s an opportunity of a risk-adjusted return, I would invest in that asset. Definitely.

RYK VAN NIEKERK: How would you describe your risk appetite?

NICK KUNZE: Probably a little bit higher than most, probably more because I’ve got the scars to prove it. I mean I lived through the times, I lived through the sort of 1990 crash, [unclear] the ’98 emerging-market bubble, all those sort of things, and more recently the great financial crisis. So I am aware of how things move and I think I’ve got a fairly good appreciation of risk – in fact to the extent I still drum into young traders who ask for advice – like people saying, ‘How much money can I make?’ – my first comment to them is, well, you should be asking ‘How much money can’t I lose?’ and that’s the way you should be looking at stuff.

RYK VAN NIEKERK: But that’s not the case in the real world.


RYK VAN NIEKERK: Many people invest, they want to make money, they want to make money quickly. Sometimes I don’t think retail investors actually understand risk properly.

NICK KUNZE: No, they don’t.

RYK VAN NIEKERK: They see an investment in Anglo in a similar vein as an investment in, say, a small cap, like say Signia, which is all over the place at the moment.

NICK KUNZE: I’ll go even further to say that any equity, an ordinary share in fact, if you had to look at a level of risk in the financial markets, pick up a book on the financial markets, any single equity is one of the most risky investments – outside of maybe geared derivatives – you could probably do as a retail  investor. People don’t realise they are very risky.

Look back at the days of Steinhoff or Sasol when it crashed, these shares can drop 50%, 60%, 70% because shares are risky by their nature.

RYK VAN NIEKERK: But yet it’s the best-performing asset class. If you speak to any fund manager, they would tell you, listen, let’s be conservative. I think we can beat the inflation rate by three or four percentage points, and that is in equity terms actually a conservative forecast, especially if you compare it to what equities have done over the past few decades.

NICK KUNZE: Yeah. I think you have  to look at the last – you are spot on – maybe the last 20, 30 years. You’re right, and look at what it has done. The last 10 years I think the market is, and I think people’s expectations, have been unfairly skewed. I think what the behaviour of the central banks around the world with quantitative easing, with artificially keeping prices, too much liquidity around, I personally think it has allowed people to be rewarded for taking risk. It’s probably a conversation for another show, but you can literally buy anything; it went up and you thought the central banks have got your back. So I think people have been rewarded for taking risks because they’ve had that sort of central bank put in the background.

But you’re right. On the general face of it for us living in South Africa life is becoming more and more expensive. We all know that the oil price is doing with Ukraine at the moment, inflation is shooting the lights out. We’ll know a little bit this afternoon – it’s Thursday here – what the CPI numbers are going to be like in America. They’re going to be probably [at] a level not seen since the 1980s, at 8%. So you are right as a South African investor, even just as a South African, you need to get a more than 10%, 12%, maybe 14% return on your money just to be ahead of inflation.

So then it goes back to your point. You can’t be sitting in cash, you can’t be sitting in the bank, because inflation is so high. So yes, the best way to outperform that is a select group of equities.

RYK VAN NIEKERK: But let’s take a scenario of a normal individual, say a person who’s also been around and has been looking at the market, watching it, and that person has his or her own share portfolio. I’m not talking about managing your retirement money. I’m talking about, listen, I’ve got R50 000 or R100 000, and I would like just to have skin in the game, and that forces me to know what is going on. How good do you think south African retail investors are, especially those in that category?

NICK KUNZE: Well, I think they’re very good. We spoke there about the financial literacy of the average investor. I think it’s gone on up leaps and bounds from 15, 20 years ago, and I think a lot of that’s to do with the ease of information with the internet world that we live in at the moment. I think a lot of it’s to do with education by the likes of the JSE. Some of the smaller houses have made access to investing easy.

Look at EasyEquities, for example. They’ve done a fantastic job about getting the retail investor interested in the marketplace, the education side of it. I honestly think it’s a great way, if you’ve got fifty or a hundred grand spare – not everyone does it these days – but to put together a basket, a portfolio, or for your kids, or try put something together, I think the tools and information are easily accessible. I think it’s a lovely way to get started. So I think a lot of the houses in South Africa are doing a very good job so far.

RYK VAN NIEKERK: And let’s talk about your best and worst investments, either as an individual or perhaps as a professional. Let’s start first off, what was the very first share you ever bought, and when was it?

NICK KUNZE: The first share I bought was – I was trading in the UK, I was living in London – was a share called Traffic Master, which actually doesn’t exist any more. But those were the days [when] it was like an old fashioned GPS. In London there’s a huge problem on the M25, which is like our version of of the M1; it goes around London and was their way of  sort of on your little smartphones. Back in the nineties smartphones were just little LED screens. But they’d work on where the traffic flow and all that was, and that was like my go-to; I read about it on one of these sort of penny-share guides, and you had to get involved and I put quite a bit of cash into the time. And of course over time it went to zero as these things do when you don’t do your homework and you take some advice, but that was my first one. I’ll never forget it. TFC was the code. I still remember, 25 years later.

RYK VAN NIEKERK: So that was a miss. What was your best ever one?.

NICK KUNZE: I think recently there’ve been some great opportunities. One that springs to mind I think was probably something like Nvidia, and I got involved in Nvidia about four years ago, when I [was at] a presentation by an offshore fund on where the internet was going with chips and graphic cards. You know the old air [we] in South Africa talk about the miners, you don’t want to own the gold miners, you want to own the companies that sell the picks and shovels. That’s the old stockbroking adage on sort of how I felt, I want to get involved in, in the ones that are doing the screens or the graphic cards or the chips and the videos, or one of them. I think I got involved in the low thirties – I think it was $32, $33. And it went up to as high as almost $300 at one point. So it’s come back quite a bit with the IT shares, but that was a great investment a few years ago. I’ve  still got them.

RYK VAN NIEKERK: After your very first investment, have you had add any other dogs you picked?

NICK KUNZE: You always have dogs, hey. You’ve always got dogs. You’re like gamblers, you never tell the losers. In our business I always remind people sometimes when you manage money and sometimes when you’re in the market, over time you just want to make more than you lose. So I’ve had plenty  misses. I’m playing closer to home in South Africa; all of us own Naspers and Prosus. That’s been a massive disappointment for all of us. I’ve got a few of them myself, and for clients. That’s been a bit disappointing. Offshore – let me think – yes, there’s been a couple offshore. We’ve got a few wrong, or a lesson too early. Amazon we were buying it sort of R3 500. It’s down under $3 000 now. But I think it’ll come back at some point. So, yeah, there have been a couple that I’ve got wrong.

Thankfully I didn’t [but] I had a couple of clients who got involved in Zoom during the lockdown. I don’t know if you’ve [ever] seen a share price that down. Talk about boom-to-bust. It’s down 80% from where it was.

So there’s been this volatility in the market. It’s easy to get a lot right and a lot wrong. We’ve got more right that we’ve got wrong, but we have plenty that I’ve got wrong over time.

RYK VAN NIEKERK: Sanlam Private Wealth has a massive research division, or access to very high-level equity research. Do you use that research in your investment decisions? Let me put it differently. Of course you use it, but is that the sole source of information on which you base your investment decisions?

NICK KUNZE: Not by a long shot, Ryk. Anything I can get my hands on, I’ll get my hands on. If I’m looking to get involved in a sector or a various theme to invest in, I want to suck up as much information [as] I possibly can. So yes, we [are] fortunate enough to have access to some clever minds in the Cape who do the number crunching for us at Sanlam, so I use their sort of ideas and thoughts as well. I also have a Reuters screen, which is quite an expensive terminal, which the firm pays for, which allows me to get access to annual reports, that sort of stuff.

As much as we’ve advanced in the, the computer age and you can buy a Bitcoin on your screen in one second on your cell phone, still a lot of old-fashioned work goes into it. I’m still one of these guys that goes through annual reports, I look at the charts, I look at the numbers, I look at the comparisons and that sort of stuff. So I do use a lot of research that’s supplied by institutions, but I also do a lot of work on my own as well.

RYK VAN NIEKERK: But if you ask any amateur retail investor, that individual will say, listen, I don’t have the skills to do that research, I don’t have the time to do it. And a lot of the decisions are taken by looking at what professional investors are doing. You can see the underlying assets within certain unit trusts, or virtually all unit trusts, and they use a gut feeling and they hope for luck. Is that an investment – ?

NICK KUNZE: The worst investment advice in my life.

RYK VAN NIEKERK: Well, a lot of people do that. They buy and hope. Yeah. Does luck play a role in your success?

NICK KUNZE: I think luck is always a portion of it – always. If you look at some of these investors over the years, you can’t tell me that a portion of that was luck. So luck sometimes goes [to] your benefit. There’s no doubt about it, but there’s also a lot of hard work.

Look, I happen to believe that this is one of the very, very few professions that are at the moment I do genuinely believe if you do your homework and you do the hours and you do your time, I genuinely think if you get rewarded accordingly, It’s not like being an accountant where you can be an okay accountant, or you can be a good accountant, or you can be a bad accountant. In this business if you’re good at what you do, you make money and you make money for your clients, for yourself, and if you’re bad at this business you lose money and you’re out of the game.

So it’s a very black and white business. Still, I generally err on the side that if you do the hours and you do the homework this business will reward you.

RYK VAN NIEKERK: But yet, if you look at the performances of many portfolio managers, many asset managers, they [do] not always beat the indices and the benchmarks. Sometimes computer-managed index funds perform really, really well. So what does that say about the prospects of a retail investor?

NICK KUNZE: I think you ought be a little bit careful in that [part have] varied spreads. So I think the likes of ETFs and passive investors and index tracking have been a revelation for the private client. You just keep entry for them. That’s been a reasonably okay for the last 10-odd years, because you could have bought anything that’s gone up, But I think recently, the last sort of six months or so, you need to be more selective. So I think that the terms have changed a little bit. Again, I think it depends on the investment style. Personally, a lot of fund managers I think are almost too diversified. I think there’s definitely a detriment; when they talk about diversification [in] the last 20, 30 years people have portfolios or fund managers that have 20, 30, 40 stocks, I don’t think how you can ever outperform the market with that many shares.

I’m a little bit on the other side. I prefer to have a very narrow band and my sort of history and my experience has shown me if I’ve rather got 10 or 12 shares I’ll tend to outperform the market far easier. A bit of a lesson for people out there. So if you’ve going to put together a portfolio, try to keep it quite narrow. Don’t buy too many various shares. There’s a risk to being too over-diversified.

RYK VAN NIEKERK: Yeah. That’s a very interesting point – being over diversified. You don’t hear that term often. Has any research been done about this?

NICK KUNZE: Plenty, plenty, plenty. There’s been plenty of research. In fact, if you look at some of the best managers over the years – I’ll take a look at someone like, I don’t know if someone who’s just listening to the show will know some of the top guys in the last few decades. There is a guy called Stanley Druckenmiller, who was the right-hand man to George Soros, which is a household name. He ran the Quantum Fund. They returned 28% return every single year, compounded for 30 years. It’s never happened before and it probably will never happen again. But they never had more than eight stocks in their portfolio, ever, at one time. Compare that to a lot of fund managers who have anywhere between 15 or 20. He’s a one-off case. But certainly there is evidence out there to prove that over-diversification – if you’ve got 20 shares of 2%, 3% in each, it’s very difficult to outperform an index that might return 10% or 15%; you’ll battle.

RYK VAN NIEKERK: Just lastly, do you look at any crypto assets?

NICK KUNZE: Full disclosure? I don’t own any, I never have done. I have nothing against them. I think they actually could potentially be a game changer in the years to come. So I’m not against them. Just until they’re better regulated it’s difficult for me to justify putting client funds in them. But I do think as an asset class digital currencies are here. They’re here to stay, but I just couldn’t tell you which one to invest in right now. But I’m not against them at all. I think they’re a very good asset class when the time comes, when they’re usable.

RYK VAN NIEKERK: Nick, thank you so much for your time and for sharing your insights.

NICK KUNZE: Thanks Ryk, it was a pleasure. I enjoyed it.

RYK VAN NIEKERK: That was Nick Kunze, He’s a portfolio manager at Sanlam Private Wealth.



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