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The case for ‘best-ideas’ funds

By Charles Younes FE Research and Opinions

Updated on Friday, 27 May, 2016

First published in FT Adviser blog, 23rd May.

When it comes to the investment community, nary a day goes by without the word diversification being uttered in some format or otherwise – and rightly so!

But while we tout the need for diversification for all investors, for portfolio managers - failure to adequately diversify could mean significant difference in returns. Diversification hands a portfolio manager the ability to smooth out shocks from unsystematic risk in a basket - idea being that the positive performance of some investments will neutralize any potential negative performance of others.

Time and again studies and mathematical models continue to show that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction.

Investing in a higher number of securities will still yield further diversification benefits, sure - but at a drastically smaller rate. Studies also show that exceeding 30 holdings, the sweet-spot say, means that the portfolio becomes too diversified and dilutes the potential for alpha.

Looking at the IA UK All Companies sector, I was first surprised to see that very few of the fund managers follow recommendations from academics.

The average number of holdings for a fund in the sector stands at 52.5. Only 17 managers (out of 204 members in the sector) actually run a portfolio with an average number of holdings that is below or equal to 30.

Fine, but what does that translate to in terms of performance?

Looking at the results from the past five years (performance ratios annualised), it first appears that “concentrated funds” did better, outperforming their benchmark by a higher margin than their “diversified” peers. This result also stands, even when adjusted for higher tracking error, as highlighted by the Information Ratio. So concentrated funds are more “truly” active than their peers and have been rewarded for taking additional active risk.

And interestingly, when you focus on risk, it appears that these concentrated funds also did better than their peers in protecting the capital.

Although their volatility in returns is higher, the median beta relative to benchmark is lower. It resulted in better performance in down markets, as evident in the better downside scores and maximum draw downs.

It’s also surprising to see that some managers in the UK Equity universe run two portfolios under the same mandate, with the only difference being the portfolio construction. These managers offer two investment solutions:  a “normal” fund and a “concentrated” or “best ideas” fund with a reduced number of holdings.

Comparing the performance between their funds over the last three and five years, you will find that the results highlight that the concentrated portfolios outperform their “normal” peers. Again, outperformance is mostly explained by excess active risk.  Taking active risk is rewarded by excess performance. From a risk perspective, results are mixed here. “Concentrated” portfolios have a higher beta and failed to protect from the downside, relative to their “normal” peers. Max Drawdown is also higher.

It’s interesting that while the sector has seemingly shunned the ideas of the academics, no matter which way you look at it – the academics are on to something; it actually pays off to run a portfolio with a number of holdings under or around 30.

The performance improves as extra active risk taken is much more rewarded by the market.

It is also unclear whether fund managers actually do a better job in protecting capital by investing into highly diversified portfolios. Actually, when you consider the results a little more closely, you will find that downside protection from concentrated portfolios is also better.

Should you choose to enquire as to why managers of portfolios with 40 to 50 names reject the suggestions of the academics, you’ll find yourself at the barrel-end of William Wordsworth’s words -

 “The education of circumstance is superior to that of tuition”.

In more prosaic words - they believe that their experience of equity markets has taught them to run a more diversified portfolio. Of course I believe this is a misjudgement – a simple attribution tool would show them they would be better off running a more concentrated portfolio made of their best ideas.

Alas, to quote Oscar Wilde: “Experience is simply the name we give our mistakes”.

Read the full research report here.