While most managers tend to over-diversify their portfolios to preserve their assets, high conviction portfolio management with a limited number of positions has its virtues.
Modern portfolio theory is categorical: diversification is the only "free lunch" that exists in management. By increasing the number of positions in a portfolio, it is possible to improve the famous risk/return ratio. In other words, diversification makes it possible to reduce the risk of the portfolio without sacrificing performance. The reason? Most securities or assets have a correlation with each other that is less than one, i.e. their movements are not totally synchronous. Thus, when one asset suffers a loss, it can be offset by the price change of another asset.
Over the past five decades, diversification has been inherent to portfolio construction. There has even been a tendency to over-diversify, with securities being included in a portfolio solely to mitigate volatility and not for their intrinsic qualities. According to many observers, this over-diversification is one of the main reasons behind the relative underperformance of most investment funds.
These arguments echo Warren Buffet's warnings against diversification. According to him, diversification is a protection against ignorance. For the famous investor, it makes no sense to invest in too many securities because it becomes impossible to analyze their fundamentals in detail. He believes that the reduction of risk comes from a very good knowledge of his files, hence the need to manage concentrated portfolios.
So, who should you draw inspiration from when building your portfolio? Should we favour diversification as advocated by modern portfolio theory or conviction management as recommended by the sage of Omaha?
Diversification versus Concentration
In a paper published in 2012 ("Diversification versus Concentration... and the Winner is?"), Danny Yeung, Paolo Pellizzari, Ron Bird and Sazali Abidin demonstrated that there is indeed a link between the level of diversification and portfolio performance.
The study suggests that fund managers are often unable to leverage their stock-picking skills because of over-diversified portfolios. Using quarterly data from 1999 to 2009, the study's authors created portfolios with different levels of diversification based on the active weights in each diversified mutual fund. Thus, some portfolios are invested only in the top 5 holdings, others in the top 10, etc. Performance and risk levels are calculated for each of these portfolios (see table below).
The study concluded that in trying to achieve a high level of diversification, managers tend to include in their portfolios securities on which their conviction is relatively low. The consequence: a dilution of the performance while weakening the Sharpe ratio (performance per unit of risk). This study also showed that the outperformance of concentrated portfolios is sustainable.
Twenty or so securities can be sufficient to reduce specific risk
In Elton and Gruber's book "Modern Portfolio Theory and Investment Analysis", the authors concluded that the average risk (as measured by the standard deviation) of a portfolio composed of a single stock is 49.2% and that increasing the number of stocks to 1,000 can reduce this standard deviation to an incompressible low limit of 19.2%. They also showed that a portfolio consisting of 20 stocks already had its risk reduced to about 20%.
Therefore, while the addition of 20 stocks already reduces the risk of the portfolio by almost 30 percent, the increase from 20 to 1,000 stocks only slightly reduces the risk of the portfolio. Thus, in the case of an equity portfolio, the benefits of diversification are realized after adding a relatively small number of stocks.
Active share as an indicator of future outperformance
The active share measures the percentage of a portfolio's assets that differs from its benchmark. According to some studies, active share is a better measure of active management than tracking error.
A manager is considered truly active (i.e. making significant bets relative to the index) when the active share is greater than 60%. Historical performance data shows that fund managers with a high active share tend to outperform their benchmarks.
What is the link between high active share and above-average relative performance?
According to some studies, funds with a high active share (and therefore with a high degree of concentration) share the following characteristics:
- Long-term investment outlook: the concept of market "myopia" has shown that markets are much harder to predict in the short term than in the long term. Managers who have a propensity to invest over time tend to outperform;
- Better access to information: managers who hold fewer stocks in their portfolios can devote more time and resources to analyzing these companies and develop a better understanding of the stocks they invest in;
- Greater conviction on their active bets: concentrated portfolios that move away from their benchmarks push managers to "dig deeper" into the analysis of stocks, which usually leads to a higher level of conviction (which allows them, for example, not to panic in downturns).
There are several explanations:
- Career risk: as JM Keynes pointed out, "it is always more comfortable to fail conventionally than to succeed unconventionally." In the fund management business, a marked underperformance for two years in a row can lead to the manager's ouster. In order not to jeopardize their careers, most managers prefer to stay close to their benchmarks and invest in stocks and sectors that have a consensus;
- Biased remuneration formulas: for the most part, the fund management business model is based on fees calculated as a percentage of assets under management. This formula encourages managers to focus on the growth of the fund's assets rather than on performance. Indeed, since unit holders do not tend to reimburse the fund in case of poor performance, managers are not inclined to take too much risk. On the other hand, few managers consider closing the fund to new clients when the size of the fund becomes too large - the famous capacity threshold at which the manager can no longer take large bets in certain less liquid stocks because of the amount under management. To avoid these capacity problems, most managers prefer to invest in large benchmark weights whose potential for appreciation is often less attractive than certain ideas off the beaten track;
- The regulatory aspect: In the US, the "Prudent Man Rule" pushes fund managers to avoid risk through diversification. In Europe, fund managers are guided by specific regulations designed to prevent fund assets from becoming too concentrated (e.g. the 5/10/40 rule within UCITs).
The assembly of concentrated funds
The concepts mentioned above are well known to institutional investors and asset allocators. When it comes to selecting external managers, some have found an interesting compromise between the possibility of outperforming indices via conviction portfolios - and therefore more concentrated - and the need to reduce the risk of the mandate entrusted to them.
Indeed, it has been observed that the strong convictions that appear in these concentrated portfolios are often the prerogative of single managers - in other words, these conviction funds rarely overlap.
These asset allocators therefore had the idea of assembling several high conviction funds, i.e. composed of 15 to 25 stocks. This approach attempts to reconcile the two worlds - on the one hand, a high expectation of outperformance (because the probability of long-term outperformance of these high conviction managers is higher than that of other funds) and on the other hand, a diversification effect that reduces the overall risk of the portfolio. The diversification effect is moreover marked since these concentrated funds have a low correlation between them (which would not be the case for funds close to the index). This approach has the merit of improving the risk/return ratio of the overall mandate.
There is, however, a downside. These concentrated, high-conviction funds tend to be invested in smaller-cap, less liquid stocks. In times of market stress, these strategies can be put to the test as the combination of concentration and low liquidity can sometimes pose problems for the manager. It is therefore imperative for asset allocators to invest in these conviction funds with a long-term horizon.