The idea is not a new one, with Keynes first singing the praises of concentrated portfolios in the 1930s, but along with ‘conviction’ and active share it has become something of an industry buzzword slapped on to fund marketing.
It has been used to tune in to the growing wave of discontent levelled at big ‘closet tracker’ funds holding all the big stocks in an index and charging an active fee for what is close to a passive service. Research from AllianceBernstein backs this, putting the rise in the status of concentrated funds down to the popularity of active share.
“This is not necessarily a logical economic consequence of the rise of passive but more a response to the way active share has become a marketing tool,” it says.
It is far easier to obtain a high active share using a concentrated fund with a limited number of holdings, but whether the whole thing is simple sales spin or offers genuine outperformance is a bit of a grey area.
The growing popularity of mandates with fewer stocks is not just anecdotal. Figures from the same AllianceBernstein report show the number of funds in Europe with fewer than 40 stocks has doubled during the past five years.
Investors clearly believe that they are reaping the rewards of funds with fewer stock holdings.
Warren Buffett famously believed running a diverse portfolio was having a ‘low-hazard, low-return’ mentality.
“Diversification is protection against ignorance. It makes little sense if you know what you are doing,” he said, a little harshly.
In a general sense, many wealth managers and investors seem to agree on the benefits of concentrated portfolios when it comes to investing in the large-cap sector, where the risk of stumbling across a closet tracker is more pronounced.
“For general funds, concentration and high active share is definitely something we are looking for,” says Rory McPherson, head of investment strategy at Psigma Investment Management.
Skerritts Wealth Management’s head of investments Andrew Merricks also tends to prefer a more concentrated approach of between 40 and 50 stocks.
“If you have too many stocks you are getting into tracker territory, particularly with large-cap funds, which is a big no-no. Also, I do think concentrated funds flag up whether the fund manager is much good or not,” he says.
Concentrated concerns
Despite this, there are concerns that should be addressed when seeking to invest in a portfolio of fewer holdings. A lack of diversity, with the accompanying issues of liquidity and the inherent risk of relying on too few stocks, are among the key areas of concern to note when investing in a concentrated fund.
Damien Lardoux, a portfolio manager at EQ Investors, adds his thoughts on how to judge if a fund is concentrated or diversified.
He says: “If you think of a portfolio of 40 stocks from across a variety of sectors, it is well diversified. I would consider this kind of fund as less concentrated than one with 100 stocks that are all in one sector or region.”
This issue of concentration both in terms of the number of holdings and across sectors is amplified in the world of small-cap equity funds, where a fund of fewer holdings must tackle issues of diversification on all fronts. Lardoux says he would not consider a small-cap fund that was too concentrated.
“I would not manage a small-cap fund of 40 stocks, it would be far too risky and there would be issues with liquidity.”
However, Lardoux does have doubts about running a small-cap fund that has a larger number of holdings. “With 150 stocks how on earth are you able to keep on top of all the companies?”
As Mike Prentis, manager of Blackrock’s Smaller Companies Trust, notes, it is nowsomewhat “unfashionable” for a manager to hold anywhere near the 150 stocks he does.
Richard Bullas, manager of the 40-stock Franklin Templeton UK Smaller Companies Fund, defends his stance, claiming there are not “hundreds of good ideas” in the smallcap space to take advantage of.
“We stick to where our competencies lie. We feel you can’t be an expert in everything,” he says.
“We do not want to be spreading ourselves too thinly, rather than having a long tail of smaller holdings we have high conviction.”
Bullas believes high conviction is key to his concentrated small-cap fund, with an estimated 80% of his outperformance coming from just 20% of his holdings.
When it comes to funds with more holdings and the so-called ‘long tail’ of smaller holdings of between 0.1% and 0.5%, Bullas argues they are almost pointless.
“[The manager] will say they like the company but I would ask why is the exposure 0.2%? Why isn’t it 2%? It’s not adding much outperformance,” he says.
James Calder, research director at City Asset Management, agrees with Bullas about the benefits of a concentrated portfolio.
“The small-cap universe is much larger and single index constituents have less impact when compared with large cap,” he says.
“In order for the positions to have an impact, a reasonable weight is required for bang for one’s buck,” he says.
Calder backs the argument for a portfolio with more conviction in the stocks selected.
“With regard to small cap, my preference is for a tighter portfolio as the manager is making a strong call, which should be a reflection of their analysis,” he says.
“The downside is that if it goes wrong it will have a much greater impact due to its relative weight to the index. Taking a bigger weight versus the index works well if you are right but can do damage if you are wrong.
“A larger number of holdings within small cap may be a reflection of the assets under management of the manager. Managing a large pool of assets leads to liquidity issues and in order to get money invested, weaker ideas may enter the portfolio. This is why we like seeing managers in this space putting capacity constraints in place,” adds Calder.
Performance data
Peter Sleep, investment manager at Seven Investment Management, raises the issue of the “career threatening” risk of underperformance, which is prevalent in funds with a concentrated, high-conviction approach.
He says: “Bill Ackman is an activist investor who runs a concentrated portfolio of about 10 stocks. Investments today include stocks like Chipotle Mexican Grill, Mondelēz and Restaurant Brands International.
If I say that one of his major past investments was Valeant, then you might be able to guess that since his launch three years ago in Amsterdam, the fund has underperformed the S&P 500 by nearly 90%.”
He adds: “When high active share, concentrated funds do well they can do really well, but when they underperform, they can be career threatening.”
Morningstar data gives us fresh insight into the returns offered by equity funds of fewer than 40 stocks, with the returns of more than 3,300 equity funds on offer to UK investors analysed.
The data shows small-cap funds have outperformed funds in the mid- and large-cap space over the last three, five and 10 years.
Over an annualised 10-year basis, smallcap funds have returned an average of 8.6%.
Funds outside the small-cap space returned an average of 6.7% over the same period. However, when looking at funds in terms of concentration, it is clear from the Morningstar data that funds with a larger number of holdings have the upper hand.
Funds with more than 40 holdings outperformed, however marginally, those with fewer than 40 during the past 10 years.
Funds of more than 40 stocks returned an average of 7.1% during the period as opposed to the 6.5% from those with fewer than 40, according to the Morningstar figures.
It suggests that while Blackrock’s Prentis might believe his approach is somewhat unfashionable, a small-cap fund with a larger number of stocks might just be the way to secure returns in the long run.
Ultimately, as with many discussions within asset management, the skill of the individual manager is crucial, with managers on both sides of the diversification fence proving their worth.
Other issues apart from outperformance of returns may come with selecting a manager with fewer stocks, whether it is from an ESG perspective where a more concentrated fund might stand out, or similarly in terms of cost, an issue growing in importance and one worthy of an analysis of its own.
