Buying highly concentrated equity portfolios could raise
costs and volatility while reducing the number of outperforming managers,
according to research.
“If the typical active manager owns 100 stocks now and converts to holding only 20 or so, the volatility of his portfolio will almost certainly increase.”While “high-conviction” strategies have seen renewed
interest in recent years, asset owners should be wary of relying too much
on concentrated portfolios, wrote Tim Edwards and Craig Lazzara, directors in
Standard & Poor’s index investment strategy department.
“Concentration only makes sense if managers have a
particular type of skill, and this skill must be intrinsically rare,” the pair
However, if high-conviction strategies were to become more
widespread, Edwards and Lazzara argued that volatility would increase. Between
1991 and 2016, the pair found that the S&P 500’s average volatility of
returns was 15%, while the same figure for individual stocks was 28%.
“If the typical active manager owns 100 stocks now and
converts to holding only 20 or so, the volatility of his portfolio will almost
certainly increase,” Edwards and Lazzara said.
This presented asset owners with a dilemma, they added:
Either they keep the same number of managers in their equity portfolio, but
reduce the actively managed proportion to keep the overall risk at the
same level, or they hire more high-conviction managers to replace the
“The increased concentration of active funds might prove
advantageous only to consultants supporting the expanded effort to secure
sufficiently diversified active exposures,” the authors wrote.
Transaction costs could also rise with fewer stocks in a
portfolio, the authors said. The higher a manager’s stake in a particular
stock, the higher the transaction cost is likely to be as a percentage of
assets if he wants to trade out.
Edwards and Lazzara also claimed that a skilled active
manager “will benefit from having more, rather than fewer, opportunities to
display his skill.” Concentrated portfolios therefore blur the boundaries
between luck and skill. In addition, managers were more likely to outperform by
focusing on cutting out underperformers, they argued.
“The logic of skewed returns”—the idea that a stock can only
fall by 100% but can increase by more—“is that it is more sensible to focus on
excluding the least desirable stocks than on picking the most desirable—the
opposite of what a concentrated portfolio will do,” they said.
The resurgence of the conviction argument was in part down
to the emergence of ‘active
share’ as a measure of how different a particular fund was from its
benchmark, Edwards and Lazzara said. In addition, there has been a “general
trend of lower dispersion among stocks” since the financial crisis, pushing
managers to put bigger bets on fewer stocks in pursuit of alpha.
Read the full paper, “Fooled
Beats Diversification, Study Finds & When
Are High Management Fees Worth It?