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The lack of portfolio concentration exhibited by many fund managers is a recipe for underperformance. In contrast, the research shows that funds with a concentrated stock portfolio tend to outperform over the long term.
The received wisdom when it comes to investing is that one should diversify, diversify, diversify! At least, this is what we’re told by the marketing departments of the large asset managers. But do you really think any fund manager could genuinely have 30, 50 or 100 good ideas? Purely intuitively, one would have to doubt that. Warren Buffett, who runs a relatively concentrated portfolio at Berkshire Hathaway, famously called diversification a “protection against ignorance”. When you look at it empirically/academically too, it turns out that the benefits of portfolio diversification hit the law of diminishing returns after an investor acquires as few as ten stocks.
Multiple studies have tried to determine the exact point at which the law of diminishing returns kicks in when diversifying a portfolio, both in terms of additional risk reduction and reduced expected returns. Benjamin Graham, Warren Buffett’s mentor and “the father of financial analysis”, put the number between 10 and 30. Meanwhile, in their book Investment Analysis and Portfolio Management, Frank Reilly and Keith Brown argue that portfolios containing 12 to 18 stocks provide about 90% of the maximum benefit of diversification. Put another way, diversify beyond that and you’ll hurt your performance but without gaining major benefits in terms of risk management.
Regardless of where you believe the precise sweet spot to be, what is clear is that most fund portfolios are WAY overdiversified. Data from Value Research Online shows that large-cap US mutual funds, on average, hold around 38 shares, mid-cap funds around 50 and balanced funds (65-70% of their assets in equity) around 52. Note that they are all way beyond the range established by widely accepted academic research. This sets these funds up for a mediocre performance at best – and that’s even before fees are taken into account!
In contrast, an unconstrained mandate and a concentrated portfolio strategy can unleash a fund manager’s performance potential. Stanley Druckenmiller, billionaire hedge fund manager and erstwhile protégé of George Soros, famously told investors “Put all your eggs in one basket – and watch that basket”. He elaborated on the concept in his interview with The Hustle on 26 May 2021:
“When I’ve looked at all the investors (that) have very large reputations — Warren Buffett, Carl Icahn, George Soros — they all only have one thing in common.
And it’s the exact opposite of what they teach in a business school. It is to make large, concentrated bets where they have a lot of conviction.
They’re not buying 35 or 40 names and diversifying.
I don’t know whether you remember that Icahn a few years ago put $5B into Apple. I don’t think he was worth more than $10B when he did that.
[In 1992] when I went in to tell Soros that I was going to short a 100% of the fund in the British pound against the Deutschmark, he looked at me with great disdain. He thought the story was good enough that I should be doing 200%, because it was sort of a once-in-a-generation opportunity.
So, [these investors] concentrate their holdings. This is very counterintuitive.”
Of course, staking the family farm on one position, no matter how convinced you are of the logic, is not for everyone – nor would we recommend it. Druckenmiller’s example is an extreme one, but it does serve to illustrate the upside potential from following your convictions and running a concentrated portfolio. For most of us, we must rely on the fund management industry – but herein lies the problem.
The lack of portfolio concentration in the mainstream fund management industry can be explained by three factors:
Career risk: As John Maynard Keynes observed, “It is always more comfortable to fail conventionally than to succeed unconventionally”. Managers that go against the herd risk exposing themselves to significant career risk if they move away from a benchmark. This is because taking a contrarian view can result in short-term underperformance, which in turn can lead to pressure being exerted by various stakeholders to remove the manager. Many funds are simply not set up to take a truly long-term view based on high conviction.
Asset-gatherer mentality: Most large asset managers prioritise maximising the amount of assets under management (AUM) rather than performance. This is because fee structures are generally structured around a percentage of AUM. In addition, few managers would consider closing a fund to new subscriptions once it reached a certain size in order to preserve performance.
Regulation: There is significant regulatory pressure on asset managers in Europe and the US to diversify to reduce risk. Examples include the Prudent Person rule in the US and the 50/10/40 rule for European UCITS funds. The latter is particularly restrictive for high-concentration, high-conviction active managers, as it specifies that no single asset can represent more than 10% of the fund’s assets, and holdings of more than 5% cannot in aggregate exceed 40% of the fund’s assets.
All this means that the asset management industry is essentially rigged to produce a mediocre performance for investors. This is an extraordinarily important point that few private investors are even aware of when they put some of their savings into funds.
Managers with a high active share (and, as a result, a concentrated stock portfolio) tend to outperform their benchmarks when this is combined with a low portfolio turnover (holding period of around two years).
So why do concentrated portfolio strategies tend to outperform? The following characteristics can help provide an explanation:
High conviction: Concentrated portfolios are the result of high conviction on the part of the fund manager. High conviction is achieved through knowing enough about a particular investment to feel comfortable about the idiosyncratic risks involved and how the position relates to the rest of the portfolio. High conviction is in turn born out of an informational edge…
Informational edge: Concentrating on a smaller number of positions enables a fund manager to allocate more resources to researching and understanding those investments.
Long-term focus: Active managers by definition believe that the market is inefficient and therefore they must be able to stomach periods where their strategy underperforms. This means focusing on the long term and sometimes sticking with high-conviction positions in spite of a period of underperformance.
Real long-term outperformance requires real conviction, which in turn leads to a concentrated portfolio strategy. This runs against the grain when it comes to the prevailing culture within most asset management firms. It is also counter to the ‘wisdom’ of many regulatory bodies. Always keep in mind: do faceless corporations and regulatory bodies in jurisdictions like the EU have your best interest at heart? (We are biting our tongue not to add our own view about this.)
Guernsey takes a different approach. Whilst its financial regulators adhere to the highest international standards and best practices, they also believe that the Guernsey financial services sector exists primarily to serve the best interests of its clients.
The GFSC (Guernsey Financial Services Commission) is prepared to work with firms to introduce products in areas it believes will help it to carve out a competitive niche internationally. It has demonstrated this time and again, in areas like the European high-yield bond market and, more recently, cryptocurrencies. It also offers fund structures that can enable managers to run a more concentrated portfolio than would be possible via a European UCITS fund, for example. In Guernsey, the client is king – and if the client is asking for a concentrated portfolio approach, the regulator will not stand in the way.
The freedom to create products around the needs and interests of the clients should be a given, but in today’s world, it’s not anymore. Luckily, some jurisdictions offer alternatives, and Guernsey is among them.
Sarnia Asset Management was established to capitalise on the opportunities afforded by Guernsey’s robust but pragmatic regulatory regime. If you’d like to discuss the themes addressed in this article in more detail, please don’t hesitate to contact us.
Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.
By James Faulkner
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