Concentration vs. diversification

Highly concentrated portfolios are more likely to perform better than diversified ones, according to a UK study of almost 600 equity portfolios.

Highly concentrated portfolios are more likely to perform better than diversified ones, according to a study of almost 600 equity portfolios.

The research was performed by London-based investment skills consultancy firm Inalytics, after the question was posed by the Royal Berkshire Pension Fund in the UK. Inalytics CEO and founder Rick Di Mascio, says the research shows that when fund managers invest in a small number of stocks they outperform their counterparts investing in a larger number of stocks.

“When we did the numbers, it reveals the portfolios with the lowest quartile of holdings performed over 400 basis points better than the highest quartile of holdings,” he says.

Di Mascio provides three explanations for the research findings:

  1. The most skillful managers are given the punchier portfolios to run. “A good analogy is that only the very best racing drivers get to drive Formula 1 cars.”
  2. The database may be biased towards successful managers who were given the opportunity and ‘survived’. “Once again there is a parallel with the Formula 1 drivers, but at least in the case of fund managers it isn’t dangerous.”
  3. The literature suggests that the lower the number of holdings in the portfolio, the more attention each one receives.

“Whatever the explanation, the data is clear – the more concentrated the portfolio the more likely the performance is going to be good,” he says.

Although David Macri, Australian Ethical CIO, agrees with the conclusion, he says that no regard was given to risk. “Concentrated portfolios are inherently more risky because of the lower diversification.”

Macri’s portfolios hold fewer stocks than most, but still hold more than 40, and tend to be more defensive, avoiding concentration in sectors such as banking and mining. He says the types of concentrated portfolios mentioned would be well suited to clients that are not adverse to risk and who have very long time horizons.

Do your clients have concentrated portfolios, or do they prefer diversification?