Investment managers can employ techniques to attempt to dampen the risk in concentrated portfolios, such as focusing on higher quality companies with strong balance sheets and avoiding leverage. Concentrated portfolios that focus on publicly-traded securities offering liquidity and transparency also hold appeal to investors who have grown wary of derivatives and other types of financial instruments that failed to deliver on expectations in the financial crisis.
Moreover, some concentrated portfolios are designed to be lower volatility strategies and may therefore entail less risk than non-concentrated strategies that hold more stocks, but have higher volatility due to, say, a particular sector focus.
Sector risk
A 100-stock portfolio with a 50% exposure to technology, for example, may have higher concentrated risk than a 30-stock portfolio that is relatively diversified across sectors and industries.
To examine the relative risk and return characteristics of concentrated versus non-concentrated global equity portfolios, our analysts reviewed the 426 products in the eVestment Alliance universe. Of these, 114 were concentrated with 50 or fewer holdings, and 312 were non-concentrated. There were 88 concentrated and 257 non-concentrated portfolios that had more than three-years of performance history.
Concentrated portfolios generally outperformed the non-concentrated group over the three-, five- and ten-year time periods. In addition, the dispersion between the best-performing products and the worst-performing was wider among the concentrated group, except for the ten-year period, when the sample size was significantly smaller.
While higher returns generally are associated with higher risk, the analysis showed that the concentrated group had only slightly higher standard deviation than, and very similar beta to, the non-concentrated group. In terms of budgeting risk for an investor’s portfolio, concentrated products did not break the bank on these measures.
On the other hand, concentrated portfolios did add a higher measure of tracking error. Investors need to be mindful of this in the consideration of whether or not to add concentrated products to the portfolio mix.
Sharpe Ratio
Two measures of risk-adjusted return – Sharpe Ratio and Information Ratio – show favourable results for concentrated portfolios. Sharpe Ratio was moderately higher for the concentrated group across all time frames, which is not surprising given the concentrated group’s higher returns and similar standard deviations to their non-concentrated peers.
Information Ratio is more commonly used by institutional investors as a measure of alpha, or excess return adjusted by tracking error. By this measure concentrated portfolios again had an edge over their non-concentrated peers.
Overall, the concentrated portfolios tended to do better than non-concentrated in terms of returns and risk-adjusted returns, while standard deviation and beta between the two groups were largely similar.
These appealing characteristics appear to be contributing to growing demand among investors for concentrated products, either as a satellite allocation to their core portfolio, or as a benchmark-agnostic strategy that can take full advantage of a global opportunity set.
Investors must pay close attention to potential downside risks in a concentrated portfolio so that the potential higher return adequately compensates investors for the inherent risk in a less-diversified portfolio. A disciplined long-term investment process, with a focus on quality, risk management and valuation, can help investors achieve those objectives in a concentrated approach.
