Deep Concentration a Review of Studies Discussing Concentrated Portfolios
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Investment Research Deep Concentration A Review of Studies Discussing Concentrated Portfolios Juan Mier, CFA, Vice President Many asset allocators today are debating whether it is possible to over-diversify portfolios. While diversification remains a central pillar in investment theory, many believe it can also dilute performance when an active portfolio owns securities to diversify rather than to add value. This, in turn, has led many observers to speculate that concentrated managers can offer investors superior performance. To help inform investors and practitioners about this ongoing debate on diversification and concentration, we have reviewed empirical studies from academics, asset managers, and other industry practitioners on concentrated equity strategies. The collection of studies spans multiple time periods, definitions of concentration, and methodologies. We divide our paper in three sections corresponding to different types of studies: first, those that provide a conceptual framework; second, those that evaluate the potential benefits of concentration on its own; and third, those that appraise the performance of the highest conviction positions derived from an underlying diversified portfolio. Our examination found that, in general terms, concentrated approaches offer many potential benefits. In the right context, these strategies may serve as valuable tools for asset allocators. 2 The first mutual fund in the United States (still active today), the the number of holdings beyond a certain threshold has a negligible Massachusetts Investors Trust, held only 45 stocks at its inception in benefit on risk reduction. While it remains sensible to diversify across 1924.1 British economist John Maynard Keynes managed the King’s managers and asset classes, there is less support to over-diversify within College, Cambridge endowment from 1921–1946. The average an individual portfolio—especially in a stock-selection context. number of stock holdings in the endowment’s portfolio was around Many asset managers appear to have realized this given the growing 46, but the portfolio’s concentration was, on average, equivalent to popularity of concentrated equity strategies. Concentrated portfolios a 17-stock equal-weighted portfolio.2 In contrast, another early 20th make intuitive sense. Why construct a portfolio that extends beyond century investor and the father of value investing, Benjamin Graham, the manager’s high conviction positions? In addition, since beta ran a more diversified portfolio. From 1946–1956 the number of exposure can now be obtained cheaply through passive index funds, common stocks held by (investment company) Graham-Newman investors may now seek true alpha opportunities from active indi- Corporation averaged 76.3 It is notable that all of these holdings are vidual managers. below the average we see today in the comparable US large-cap space. But has it worked? Many studies have directly compared the perfor- We believe that active managers began increasing their holdings after mance of concentrated versus diversified strategies. Other studies have the creation of the first index fund in the United States in the 1970s. investigated the performance of a manager’s highest conviction posi- These vehicles made broad-market benchmarks investable, leading to tions (drawn from a more diversified portfolio), and have considered investable indexing strategies and a new emphasis on relative perfor- whether these positions are more likely to outperform. Several papers mance. With metrics such as tracking error, managers were evaluated assert that concentrated portfolios that, by definition, represent top on how closely their active return pattern tracked an index. Often, ideas would post favorable results. managers found it necessary to construct stock portfolios with dozens (or even hundreds) of holdings so that the pattern of performance As part of our review of these studies, we have divided our paper resembled the index, while also attempting to add value—an inher- into three sections. Each section corresponds to the type of studies ently contradictory set of goals. and closes with our appraisal of their findings. In the first section, we review some fundamental concepts to our discussion on concentrated Since 1983, the average number of holdings in US large-cap mutual studies (the Appendix discloses our search criteria for papers). funds has steadily climbed. This remains valid whether index funds are excluded (left chart in Exhibit 1) or not (right chart in Exhibit 1). We believe that expanding our analysis to, for example, the small-cap or 1. Background and Related Concepts international equity universes would reveal even higher numbers given In 1989, Richard Grinold introduced the Fundamental Law of Active the breadth of these opportunity sets. Management (the Law). This concept provided a framework to judge an active manager’s ability to add value. As measured by the informa- The concept of diversification based on Harry Markowitz’s work on tion ratio, it can be expressed in terms of two dimensions: skill and portfolio theory showed how investors can reduce risk without forgo- breadth.6 (See Appendix for formulas.) ing return by adding uncorrelated assets.4 This remains a central tenet of finance theory. However, it appears that some portfolio managers Theinformation ratio (IR) assesses risk-adjusted performance by divid- use the concept of diversification to justify holding too many stocks. ing benchmark-relative excess return over tracking error (standard It has been shown that mathematically, an investor obtains the big- deviation of excess returns). In the Law, the IR is decomposed into gest risk-reduction benefit (in terms of standard deviation) by adding the information coefficient(IC), which is the correlation of return 20–40 securities.5 The sharp drop in risk occurs early on; thus, raising forecasts with realized returns, and breadth, which is the number of Exhibit 1 Average Number of Holdings in US Large-Cap Mutual Funds Excluding Index Funds Including Index Funds 180 180 120 120 60 60 0 0 1983 1988 1993 1998 2003 2008 2014 1983 1988 1993 1998 2003 2008 2014 Number 6 69 146 323 592 824 1122 6 71 162 352 655 898 1221 of Funds As of December 2014 Data include equity mutual funds in the Morningstar Category for US Large Cap with inception date prior to 31 December 2014, and excludes fund of funds. Source: Morningstar 3 independent investment decisions. In turn, IC can be thought of as signal their skill. The cognitive impossibility of attaining in-depth the “skill” component and breadth as the number of “bets” a given knowledge on hundreds, or even thousands, of securities, means that manager makes. the specialization of high-conviction managers on a small number of names bodes well for adding value. The Law prescribes an interesting interaction between these variables. That is, a highly skilled manager can have less breadth and produce In addition to their insights on high-conviction managers, the authors the same IR than another one with more breadth, given differences draw some interesting conclusions about diversified managers. in skill: to get an IR equal to 1 an IC of 0.15 implies breadth is 44; Diversified managerscan add value, especially those from firms with an IC of 0.05 implies breadth is 400 to reach the same IR of 1. This deep resources and efficiencies in information gathering efforts. But has direct implications for managers of concentrated portfolios, as it from an investor’s standpoint, constructing a portfolio of diversified implies the necessity of very high skill to successfully manage a portfo- managers can mean that the active bets (which are smaller than the lio with very few holdings.7 active bets of concentrated portfolios) are more likely to cancel each other out. Moreover, returning to our discussion on the Fundamental Joint research between Lazard and Brandes in 2014 published as The Law, the breadth of diversified managers is smaller than it appears by Predictive Power of Portfolio Characteristics, adapted the Fundamental simply considering their investment universe. This follows because Law as a tool to rank managers. Active share and concentration coef- breadth in the Law implies independent bets, and it is often the case ficient (we discuss these in more detail below) are proposed as proxies that shortcuts to screen a security universe are not independent (for for skill and breadth. Key takeaways from that study are that concen- example, eliminating groups of stocks based on market cap). tration will rank a manager favorably only as long as it can maintain a high (or increasing) level of active share. This ranking methodology In our next section, we consider research on what makes a portfolio exhibited some degree of predictive ability. concentrated, and how that may benefit investors. As noted earlier, research on the added value of active management centers on aggregating results of the universe of active strategies. 2. The Characteristics and Potential However, looking deeper within the set of active managers results Benefits of Concentration in interesting evidence. Cremers and Petajisto (2009) and Petajisto There is no consensus on how many stocks define a concentrated port- (2013) introduced active share to measure how much a portfolio’s folio. Some practical approximations provide loose guidelines, such holdings differ from its benchmark. Active share ranges from 0% as 30 stocks or less for US equity portfolios or 40 stocks or less in a (portfolio weights are identical to the benchmark) to 100% (portfolio broader international/global portfolio. But this approach says nothing holdings do not overlap at all with the benchmark). about the individual security weights. Other measurements are based The researchers found that high active share portfolios outperformed on the weight of the largest 10–20 holdings, but this fails to capture in a US equity mutual fund universe. Funds were sorted in quintiles overall concentration. by active share and subsequently by tracking error; depending on the The lack of a strict definition of concentration complicates com- ranking within these two dimensions funds were labeled to describe parisons of results.