Funds made up of 40 or 50 stocks have been on the rise, and could arguably have become something of the norm in an industry looking for the next best investment ideal.
Recent research by Alliance Bernstein found the number of funds with less than 40 stock holdings had doubled over the last five years, and Mike Prentis, manager of the BlackRock Smaller Companies Trust, recently suggested it was “unfashionable” for managers to have 165 holdings in a portfolio, as he currently does.
The attraction of the highly-concentrated portfolio could be in its simplicity, and perhaps the chance that a lower number of stocks will result in a cheaper product at the end of the day.
The emphasis on active share and the evidence that this fund is not a closet tracker, has also had an impact with more concentrated funds scoring north of the sweet ‘50%’ spot better able to claim they are ‘truly active’.
The same AB research found: “Whether seeking higher active share is theoretically desirable or not, we find that in practice portfolio managers who run ‘fundamentally-driven’ equity portfolios have been under increasing pressure to raise active share in recent years.”
Many hands make light work
The success of largely diversified managers, such as former Fidelity man Anthony Bolton, would suggest concentration is not the be all, end all. Asking whether he would have had the same success without a busy team of analysts behind him, however, remains a question for another time.
In a small team without the extensive research support, as at Franklin Templeton’s UK equity team, highly concentrated portfolios are an admission of the simple fact that a single manager cannot fully know the ins and outs of every holding in a diversified portfolio as it breezes past the 100 stock-mark.
Richard Bullas, manager of the firm’s smaller companies fund which has about 45 holdings, said: “We stick to where we are competent. We focus on companies and industries that we understand, we have to know them in depth.”
It is also often the case that concentration and conviction are presented as hand-in-hand, the former presented as a happy by-product of the latter. As a concentrated small-cap manager, Bullas agrees conviction is key and questions whether more diverse holdings have the same belief behind them.
“If they say they like the stock I would ask why is it around 0.2% of the portfolio? Why isn’t it 2%?”, he says as an example.
The AB research touches on this discussion of concentrated funds.
Stock selection is key
It found that as the number of stocks in a portfolio declines the probability of including one of the winners also drops, but admitted this does not take into account managers’ stock selection skills.
“The conclusion that the anti-active brigade takes from this is that it is therefore better to simply buy the whole index passively as then one can be sure of owning the winners,” it said.
“If the mean return of stocks is higher than the median and stocks are selected at random into portfolios then they are indeed entirely correct.”
It goes on to add: “However, most active managers would deny that they select stocks at random. If such managers are actually good at selecting stocks, in a world where most investors are long-only, then a positively-skewed distribution is a huge boon.
“Such managers could take advantage of a long upward tail of returns to differentiate their returns from the benchmark.”
As with many things in investment management, from fees to active share to concentration, it comes down to the individual manager.
Does their performance justify the stock selection? Does it justify higher fees? Do they really need to up their active share if investors are already beating the index?
With both concentrated and more diversified funds it rests on whether the manager makes the right call on the stocks in the portfolio, they have to use their skill to up performance and justify their process.
