It is a truth universally acknowledged that the best fund managers run concentrated portfolios with high active shares.
But what about those managers who are aware that they may not be the best? Assuming that arrogance is not so pervasive in the industry that such people exist, they are faced with a choice. They can either build diversified portfolios that essentially track their benchmark and minimize the chances of underperformance, or they can try to construct a concentrated portfolio that may pay off and that should suggest a certain level of confidence and quality to fund buyers.
A new paper by Keith Brown and Uzi Yoeli of the University of Texas at Austin and Cristian Tiu of the University at Buffalo explores this issue. Are concentrated portfolios a reliable indicator of a manager’s talent, or are they just as likely to be deployed by charlatans?
Plenty of studies have shown that concentrated portfolios outperform, but this could just be a matter of correlation rather than causation. Perhaps unskilled managers with relatively few holdings have simply been lucky in this long bull market.
First, Brown, Yoeli and Tiu established whether a manager generated alpha and then looked at whether these managers went on to run concentrated portfolios.
‘Rather than use the manager’s concentration decision to help explain the portfolio’s subsequent performance,’ they noted, ‘our goal here is to explain how the manager arrived at the portfolio concentration decision in the first place. This means that the causality we propose runs from forecasting skill to the portfolio composition choice and not the other way around.’
Using data from the Center for Research in Security Prices, they focused on actively managed US equity funds between 2002 and 2015. They examined concentration through the number of holdings in a fund and according to the Herfindahl-Hirschman methodology. Manager skill was considered by both factor-adjusted alpha and benchmark-adjusted alpha.
Good things in small packages
This process established that there is indeed a strong relationship between investment prowess and portfolio concentration.
For example, a manager who produced 10 basis points of alpha per month above their average competitor – or 1.2% on an annualized basis – typically held 6.4% fewer positions than their average peer. As a result, while the median number of holdings in the whole sample of funds was 75, managers with this level of additional skill oversaw portfolios of approximately 70 stocks instead.
The authors also discovered that larger funds tend to be less concentrated – as may be intuitively expected given the practical considerations of managing billions of dollars – and funds with higher expense ratios tend to be more concentrated.
‘A useful consequence of our analysis is that it provides a conceptual explanation for the long-established empirical result that more concentrated portfolios tend to produce superior investment performance,’ Brown, Yoeli and Tiu concluded. ‘Our model of the skill-concentration relationship clearly runs in one direction: it is the manager’s superior forecasting ability that leads to the benefits of forming a smaller, more concentrated set of holdings.’
Time to concentrate
Holders of concentrated funds should therefore be reassured. ‘External asset owners – i.e. those who hire the manager to invest their positions for them – cannot observe a manager’s skill level directly but they can observe the size and composition of the portfolio that he or she forms,’ the academics noted.
‘So it is possible that low- or no-skill managers might assemble concentrated portfolios as a marketing strategy in an attempt to signal to potential investors a level of skill that they do not truly possess. However, our empirical findings show that this is not the case for the cross-section of the mutual fund industry we examined, which supports our overall conclusion that investors are well served by selecting genuinely skilled fund managers who hold portfolios that are less than fully diversified.’