Every equity fund manager has a favourite stock story. Irrespective of how a manager picks stocks, there is invariably one – and sometimes there are a few – that stand out from the rest of the market and which demonstrate powerfully how the manager does its job.
But these stocks may not have a chance to shine if they are part of a portfolio that includes a large number of other stocks besides, some of which are there to moderate the performance of the portfolio so it does not drift too far away from the characteristics of a given benchmark or market index.
A conundrum facing active managers arises from the increasing popularity of low-cost, passive approaches such as exchange traded funds (ETFs), and from the growing number of factor-driven, “smart beta” options.
An active manager must produce returns that exceed passive smart-beta options in order to justify its fees, but it must do it with a level of volatility that doesn’t spook too many investors. One response to this is for active fund managers to produce concentrated versions of their core equity portfolios.
Concentrated portfolios represent the best ideas of an investment team, and while many investors have been raised to believe that the more stocks a portfolio holds the better diversified and less volatile it will be, concentrated funds invite investors to contemplate diversification and volatility in a slightly new way.
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Concentrated funds may well be more volatile than core funds from time to time, but that volatility may be quite different from the broader market. They are also expected to compensate by producing higher returns over time.
Patrick Noble, a senior investment specialist with Zurich Investments, says that while a concentrated fund can have higher volatility, “it is not necessarily always the case”.
“That is, best conviction ideas can perform relatively well in rising and falling markets, so long as [what’s driving the fund’s holdings] are not the drivers of broader market volatility,” Noble says.
Counter-intuitive volatility
Quan Nguyen, a senior investment analyst with Zenith Investment Partners, says the 20 diversification benefits of a concentrated portfolio can be counter-intuitive.
“In Australia, if resources are really volatile or the banks are really volatile then a core portfolio can be more volatile than a concentrated fund because [the concentrated fund] won’t have to hold benchmark weights there,” Nguyen says.
But the opposite holds true as well – a concentrated portfolio may be more volatile than a core portfolio if the concentrated portfolio has a relatively higher exposure than the core portfolio to the sectors driving market volatility.
Nguyen says a typical core fund’s holdings might number more than 100; a concentrated fund will typically hold a minimum of 20 stocks, but only as many as perhaps 40 or 50. Some hold even fewer than that.
For a global equity fund manager, it is a very high level of concentration when one considers there are literally tens of thousands of companies listed on stock exchanges around the world.
Already concentrated
Nguyen says the Australian equity market is itself already quite concentrated. Investing in the broad market index “is like holding the equivalent of roughly 20 to 22 stocks in equal weighting”, he says.
“If you hold the index, at the moment CBA is 10 per cent, and the other banks are quite large as well,” he says. “When you hold a concentrated fund in Australia, you get to diversify that a bit more. You don’t have to hold the four banks that make up 25 per cent [of the market]; you can hold one bank and diversify sectorally.”
Globally, however, markets tend to be less concentrated in speci c sectors or stocks. Nguyen says the bene t of concentrated portfolios, wherever they invest, is that investors are able to exploit the best ideas of a skilled investment team. A core fund will inevitably “hold some stocks they don’t want to hold, just because it’s in the benchmark”, Nguyen says.
“That’s truer in Australian equities than globally, because even if you don’t like CBA, for instance, because it’s 10 per cent [of the market], they have to hold it,” Nguyen says. “In a concentrated fund, they do not have to hold it.”
Noble says Zurich has been in partnership for the past six years with American Century to o er the Zurich Investments Global Growth Fund, which holds between 90 and 110 stocks. It’s launching a concentrated version of the fund that will hold 30 to 50 of the American Century team’s best stock picks.
