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 wrote.
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 diversification benefit.
“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 by Conviction.”
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