When is Diversification a Bad Idea?

New research suggests concentrated equity portfolios outperform diversified ones.

(April 30, 2013)–Here’s something to blow your mind: Diversified equity portfolios have been found to underperform highly concentrated ones.

This quirky piece of knowledge hails from Inalytics, the London-based consultancy asked to look into the area by Nick Greenwood, pension fund manager at the Royal Berkshire Pension Fund.

After studying Inalytics’ database of 599 equity portfolios, the consultant found that–contrary to popular opinion–highly concentrated equity portfolios performed almost 400 basis points better than the most diversified ones.

“One possible rationale is that only the most skilful managers are given the punchier portfolios to run,” Inalytics CEO Rick Di Mascio wrote in his note on the findings.

“A good analogy is that only the very best racing drivers get to drive Formula One cars.”

A second reasoning could be that the results are biased towards successful managers who were given the opportunity to be punchy with their allocations, and survived.

Finally, Di Mascio opines that it could be due to basic tenants of behavioral finance: The fewer stocks you have to look at, the more time and care you can spend on them.

“The data is clear; the more concentrated the portfolio, the more likely the performance is going to be good, but be ever mindful that ‘Only the Strong Survive’,” he concluded (liberally taking the opportunity to quote from Jerry Butler and Elvis).

In addition, aiCIO asked Royal Berkshire’s Greenwood what prompted the query. “Just a long-held view that there are good companies, bad companies and average companies (which make up the majority), and that investors should focus on good companies,” he said. 

Inalytics would be well advised to pass this knowledge on to the UK’s public sector. At Aon Hewitt’s annual fund manager conference, held earlier this month, the consensus for public funds was still racing towards greater diversification.

Emily McGuire, head of public sector investment consulting at Aon Hewitt, said in a statement after the event: “We are already hearing (about) an increased appetite to learn about Liability Driven Investment and a continuing trend towards diversification.

“We also expect to see more interest in infrastructure, hedge funds and diversified growth funds this year, as public sector schemes–like those of the private sector–seek greater value at a time when it can be elusive.”

Few would argue against the fact that diversification, in general, is still a noble quest. However, Inalytics research has shown that we don’t necessarily have to be diversified within each asset class. Once again, we learn that one size doesn’t always fit all. 

Related News: Risk Factors 0.0 and The New Alternatives

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