David Allen

The idea that a fund manager must hold a concentrated portfolio to significantly outperform the benchmark is an enduring investing legend.

However, when you look at the data, this widely held conclusion seems somewhat questionable. Afterall, Renaissance Technology, the most successful hedge fund of all time has generated returns in excess of 70 per cent p.a. before fees and has several thousand positions at any one time.

So, let’s dig in a little deeper.

Have concentrated managers generated superior performance to diversified managers on average over time?

The star manager effect

For decades, the idea of the “star fund manager”, with a perceived extraordinary ability to identify the super compounders hiding in plain sight, has reigned supreme.

Typically, the portfolios of star managers have been concentrated with less than fifty holdings.

The chart below shows the average performance of global equity funds vs. the MSCI World by number of holdings over the last two years. For this analysis we took every global equity fund in the Morningstar database that reported holdings and performance data.

The results are striking. The most concentrated portfolios, holding less than 25 stocks imploded, underperforming by an average of 11.1 per cent over 2022 and 7.5 per cent p.a. over both 2021 and 2022. Portfolios with 25 to 50 holdings also underperformed. These averages obscure some rather frightening underperformance from individual funds, with several underperforming by 30, 40 and 50 per cent.

Source: Plato Investment Research, 12/22

Yes, Buffett has long rallied against the evils of “diworsification” – arguing that one should instead put all their eggs in one basket and watch that basket. However, this model has come crashing back to earth with many marquee managers underwater versus their benchmarks not only in 2022, but since inception.

The longer-term evidence

You could argue the above chart doesn’t provide a conclusive illustration of the performance of high concentration, covering a period which was predominately a bear market.

An analysis of the longer-term performance of concentrated managers versus diversified managers was also conducted by Morningstar.

Morningstar Research Services looked at the concentrated portfolios argument using a massive sample of US mutual funds between January 1994 and December 2018.

They concluded there was no statistical difference between the performance of the most concentrated and the most diversified funds. However, they did find that the more concentrated funds tend to have higher fees and more unpredictable returns.

“There isn’t a significant relationship between portfolio concentration and gross returns among U.S. equity mutual funds. Yet, concentrated managers tend to charge more, and the risk of manager selection is greater for these funds because of the wider range of potential returns between winners and losers.”

Active share: A superior proxy for conviction?

Active share measures the differences between a portfolio’s holdings and its benchmark.

In the below diagram, the dark blue area is the overlap between the holdings of a portfolio and its benchmark. The light blue area represents the non-overlapping holdings and is referred to as the active share. An index fund will have an active share of 0 per cent, and an equity fund with no holdings in common with the benchmark will have an active share of 100 per cent.

Illustration of Active Share

A portfolio that capitalisation weights the thirty largest holdings in the ASX 300 is not what most people would describe as high conviction.

The active share metric correctly diagnoses this with an active share of just 30 per cent. Perhaps unsurprisingly, funds with the highest active share tend to outperform the market, whereas highly concentred funds do not.

The active shares of all global equity funds in the Morningstar database are shown below, ranked low to high.

A final word

The key takeaway from all of this is the data shows like most things in life, there is more than one route to success. Star managers and ‘best ideas portfolios’ might work in some cases, but to generate strong investment returns through-cycle, investors should remain open-minded and question if the data behind conventional wisdom really does stack up.

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