One Reason to Diversify by Alpha

The article was published in the June 2022 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

When building a portfolio, you naturally want to balance asset classes and risks. You want value and growth. Domestic and foreign stocks. Short-term bonds and long-term bonds. High-quality and junk bonds. Small cap and large cap.

But when fund companies or consultants are combining managers with styles that overlap, they often think in other terms. They think about diversifying by sources of alpha. One subadvisor might focus on momentum, another on fundamental analysis, a third on high quality. All of those have some overlap, but they also have key differences that can make adding an additional subadvisor a good thing because they have different sources of alpha.

When I put together my own portfolio, I have a slightly different take. I want diverse alpha by manager and analyst staff. The best firms have distinct sources of outperformance that come from having elite managers, analysts, quantitative tools, and trading desks. Thus, I see real benefit to trying to tap more than one elite investment team. (Low costs via passive funds or low-cost active funds are another way to add value, though technically that’s beta, not alpha.)

When I looked at my portfolio last year, I was struck that I didn’t own any T. Rowe Price equity funds. I did own T. Rowe Price High Yield PRHYX in my 401(k). The omission is partly because T. Rowe closes some of its funds to new investors, but still. T. Rowe Price has some of the best technology and healthcare analysts out there, and the firm is not too shabby in other sectors.

I had loads of exposure to Primecap and Dodge & Cox (no surprise to longtime readers). I had Oakmark, American Funds, Pimco, and one Artisan fund. But T. Rowe Price’s great analysts and managers weren’t there. When T. Rowe Price Mid-Cap Growth RPMGX reopened in December 2021, my ears perked up. It has a Morningstar Analyst Rating of Gold and is run by Brian Berghuis. Of course, growth was pretty pricey, so I didn’t rush in.

However, when the growth meltdown got going in May, I made my move. It went down some more, and I bought some more. I also bought some value and bond funds as the selloff continued. But it felt good to get in on T. Rowe Price Mid-Cap Growth, and I’m more likely to add to that position. T. Rowe’s funds in small- and mid-growth have been outstanding. This fund has a huge asset base, so it won’t nimbly dive into small names at just the right time, but I am optimistic it can find some of the best mid-cap names and is taking advantage of this selloff to add to favorite stocks that will add zest on the way up.

Where might I be wrong? The biggest risk is probably that this is like June 2000, of the 2000-02 bear market, and growth has a long way to fall before coming back. That’s certainly a possibility, though I think the fundamentals in growth are much better than they were in 2000, even if there is plenty of froth.

Another risk is that Berghuis could retire in a few years. That doesn’t feel like as big a risk, however, because T. Rowe Price has a deep bench that usually is able to maintain outperformance even when a star manager retires.

Conclusion

It’s worth looking at your portfolio from this angle. Are there some great investors you lack, and do they happen to line up with an area that you need? If so, you might want to build up your prospect list of great managers and firms that you don’t own.