Picking winners: is diversification blunting investment returns?

Most active funds underperform the market, but money managers say there are skilled professionals out there who can justify their fees. The key, some say, is to invest in high-conviction managers who opt for concentration above diversification, managers who invest in dozens rather than hundreds of stocks. Are they right?

There is such a thing as too much diversification, the argument goes. Many active funds are closet trackers, containing so many stocks that their performance is bound to mimic benchmark indices as opposed to outperform them.

Concentrated portfolios containing a relatively small number of stocks are a better idea and more likely to outperform for one simple reason – they are more likely to contain a manager’s best ideas. Adding more stocks to the mix would only water down exposure to these ideas, so investors should opt for concentrated portfolios, trusting their money to managers who have the courage of their convictions.

That’s the theory anyway. Does the evidence support it?

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Well, it's true that to beat the market, you have to be different to it. A portfolio consisting of 15 random stocks has a 27 per cent chance of beating the market, according to a study by money manager Robert Hagstrom, but the odds fall to to 18 per cent for a 50-stock portfolio, 11 per cent for a 100-stock portfolio and only 2 per cent for a 250-stock portfolio.

So, opt for concentration over diversification? Not so fast.

The downside is that the fewer the stocks you hold, the greater the chance your portfolio won’t include the handful of stocks that have historically accounted for the bulk of stock market returns.

A landmark 2017 study by Prof Hendrik Bessembinder found that, historically, most stocks have failed to beat risk-free bonds. The only reason stock markets have been an excellent investment is because of the gargantuan returns generated by a handful of stocks (think Apple, Amazon and the likes). A portfolio consisting of 30 or 40 stocks is less likely to contain the small minority of companies that save the day for investors and thus runs the risk of serious underperformance.

Best ideas

What about the idea that concentrated portfolios are more likely to contain a manager’s best ideas and, thus, are more likely to outperform? There is some evidence to support this thesis. A 2010 paper, Best Ideas, found a fund’s top holdings, which are assumed to be a manager’s high-conviction ideas, comfortably beat the market only for the fund’s performance to suffer due to the poor returns of its smaller holdings.

That’s evidence managers have skill, the study suggested, but this skill is neutralised by institutional pressures that encourage excessive diversification.

A 2012 paper, Diversification Versus Concentration . . . and the Winner Is?, came to a similar conclusion, as did a 2017 paper, The Decision to Concentrate. It is the “superior skill of the manager that leads to the decision to form a concentrated portfolio in the first place”, said the authors of the latter study, with skilled managers opting to select only about 3-20 per cent of the available stocks to them.

Although less skilled fund managers could build a concentrated portfolio to give the impression they are skilled, confident operators, the researchers found no evidence that this occurred. Consequently, they concluded investors “are well served by selecting genuinely skilled fund managers who hold portfolios that are less than fully diversified.”

Super-stocks

Not everyone is convinced, however. Earlier this year, index fund giant Vanguard replicated the findings of Bessembinder and other researchers, namely that stock markets tend to be dependent on a small minority of super-stocks. Almost half – 47 per cent – of stocks have historically been unprofitable investments, Vanguard said. Almost 30 per cent lost more than half their value.

On the other hand, 7 per cent of stocks enjoyed massive gains that exceeded 1,000 per cent.

“Rather than raise the outperformance odds, increasing concentration lowers them,” Vanguard cautioned. “The less diversified a portfolio, the less likely it is to hold the small percentage of stocks that account for most of the market’s long-term return.”

If you don’t hold those extreme winners, you’re doomed to underperform. According to Vanguard, the chance of a one-stock portfolio outperforming the market is only 11 per cent. This rises to 34 per cent for a 10-stock portfolio, 43 per cent for a 50-stock portfolio and 48 per cent for a 500-stock portfolio. The more stocks, the better.

Doesn’t this contradict Hagstrom’s aforementioned finding that you have little chance of outperforming an index if you hold hundreds of stocks? Not necessarily. Vanguard’s analysis doesn’t account for management fees.

A 500-stock portfolio might have a near 50-50 shot of outperforming, but the margin of outperformance is bound to be very slim, and not enough to cover annual management fees.

Similarly, Vanguard agrees that a concentrated portfolio gives you a better shot at serous outperformance. The odds of a 100-stock outperforming by more than one percentage point annually are 10 per cent; if you decrease your holdings to 30 stocks, however, your odds of decent outperformance increase to 19 per cent.

Unfortunately, the reverse is also true; the more you decrease the number of holdings, the more likely you are to badly underperform. Worse, as you decrease your holdings, “the chance of underperformance increases at a faster rate than the chance of outperforming”.

Similarly, the idea that top holdings reflect a manager’s best ideas may be misplaced, says Vanguard. It gives the example of a manager who invests an equal amount of money in five stocks. A year later, let’s say stock A has returned 30 per cent, stock B 20 per cent, stock C 10 per cent, stock D 0 per cent and stock E has fallen 10 per cent.

Stock A will now be the largest holding, but it wasn’t the manager’s best idea or a high-conviction pick; it was one of five equally good ideas. Vanguard also notes that a manager may be adept adding to the more profitable positions over time, or cutting back on losing positions. Thus, “it would be inaccurate to conclude that the current largest positions were the initial or current best ideas and should have been the sole investments in the manager’s portfolio”.

Little relationship

Vanguard’s scepticism is shared by Morningstar’s Alex Bryan. Too much diversification reduces the odds of strong outperformance, Bryan found in a recent study, while a concentrated approach increases the odds a manager will miss the big winners which disproportionately drive market returns. These two factors offset each other: overall, Bryan found little relationship between portfolio concentration and gross returns. However, concentrated managers tend to charge higher fees, suggesting investors are “willing to pay up a bit for bolder active bets” – not a good idea, considering higher concentration didn’t actually generate better performance.

“The idea that investing with conviction improves returns is a myth,” says Bryan. “Increasing portfolio concentration is just as likely to hurt returns as it is to help.”

Despite charging higher fees, concentrated funds don’t have significantly better odds of success. Furthermore, things can go wrong if you select the wrong manager, “so proceed with caution”.