Concentration vs. Diversification

Concentration vs. Diversification
This topic on “concentration” was triggered by a number of recent articles about managers focusing on concentrated portfolios, the latest a blog by Jonathan Chevreau on “Steadyhand- A fund family for mutual fund sceptics” . Chevreau talks about Tom Bradley’s new actively managed five -fund family which differentiates itself by charging reasonable management fees (by Canadian active mutual fund standards) and holding concentrated portfolios. Staedyhand portfolios are composed of only about 25 stocks (a little more for the global one). But this blog is not about Steadyhand, which doesn’t yet have a track record (though the managers’ track records are available for the asking).
Much of what is advocated at this website is about finding the strategic asset allocation compatible with the investor’s risk tolerance and then building a portfolio which implements it with low management fees. The message has been that few fund managers (less than 20%) can sustainably beat the indexes, especially after management fees. While we can tell after the fact who were the few managers that beat the indexes, it is very difficult (impossible?) to do so a priori, so why not just proceed and build the portfolio mostly with passive (index) building blocks.
As more and more investors reach the above conclusion, the pressure is building on the fund managers to justify their management fees and demonstrate that they are not just closet indexers (and with 200-300 stocks in many funds many may well be) and in fact they can outperform the appropriate indexes. You’ll likely be hearing more and more about concentration as a differentiator. (Hedge funds also take concentrated approach and may also add some leverage, short and/or derivative positions.)
I will try to summarize the insights on ‘concentration’ based on a couple of recent articles I came across, one by Whitney Tilson in the Financial Times entitled “Strong stomach? Concentrate that portfolio” and Christopher Wright’s “Diversifitration-What do ‘diversification’ and ‘concentration’ really mean” in CFA Magazine, September/October 2007 that take a stab at concentration.
Warren Buffett appears to have been an advocate of concentration. The following couple of quotes are attributed to him: “Because truly superior ideas are few and far between, the impact of owning them should not be diluted by ideas that are anything less than superior” and “Wide diversification is only required when investors do not understand what they are doing”.
Concentration is not about putting your portfolio into a couple of high flying technology stocks in the late 90s, or for that matter into gold and wheat in 2008. It is about a fund with perhaps as few as 10 and perhaps as many as 25 stocks, and putting as much as 50% of the portfolio in the top two and 70% in the top five! Clearly it is about putting your money in the stocks that you spend time to understand well and have the conviction that they are mispriced and then weighting the proportion of invested funds in each by the extent of your conviction. The result (if you are right) can be index-beating by 100s of basis points, but you must be able to live with outsized volatility (risk). Managers who operate concentrated portfolios believe that they are taking less risk by investing in 10 stocks they really understand than by adding another 30 or even 100 stocks (about which they have and can have relatively little understanding) for diversification.
Diversification is about adding additional stocks (with low or negative correlation) to the portfolio/fund in order to reduce (not eliminate) volatility (risk). Studies have shown that one may get 90% of the benefits of diversification with as few as 20-40 stocks. So even a portfolio of 20-25 stocks may be diversified if they “won’t necessarily all react to the same thing at the same time (e.g. oil companies and airlines)” Osterweis of Osterweis Capital Management says that “I would contend that with a portfolio of 25 really well researched companies not all in the same industry, we actually may be more diversified in a more significant way than funds that own two or three times as many positions as we do.” and that “There aren’t that many really great ideas out there. As you start getting beyond 25 or 30 names, you’re just filling up the portfolio with mediocre investments.”
Wright points out that some studies have shown concentration just leads to higher volatility without higher returns, but then he finishes off with three possible advantages of concentration: (1) volatility is harmless (if you really have the conviction to hang tough and the understanding of your picks), (2) asymmetric returns (if you can do your homework to achieve a margin of safety by minimizing the downside and maximizing the upside) and (3) layering (by including one or more concentrated funds and treat them as individual stocks).
So on the surface ‘concentration’ may make sense; if you can live with the increased volatility and can find managers who will consistently outperform (not a cakewalk). Then, you may want to include some concentrated funds in the satellite portion of your ‘core-satellite’ portfolio.
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