Skip to the content

Concentrated funds: Is less really more?

27 May 2016

FE Trustnet speaks to financial professionals regarding the number of holdings within portfolios. Is a smaller number of stocks more likely to lead to outperformance or simply increase risk?

By Lauren Mason,

Reporter, FE Trustnet

A smaller number of holdings within a portfolio is likely to lead to stronger returns, lower downside risk and greater alpha generation, according to a number of investment professionals, who believe that over-diversification can be risk overseen by many investors.

The debate surrounding the number of stocks that a fund manager should hold is well-known – while those that prefer portfolios to hold a greater number of stocks argue that the fund is better diversified, those that prefer more concentrated portfolios say this approach is less susceptible to down markets and offers higher growth potential.

Those that prefer funds to have a larger number of holdings also argue that they are lower risk than their concentrated peers, given that they often boast lower levels of volatility and can smooth out returns.

However, the FE Research team found that, when comparing a portfolio of funds with more than 30 stocks to one with 30 or less stocks in the IA UK All Companies sector, the funds with fewer stocks have on average provided better downside risk scores and maximum drawdowns, despite the fact that their annualised volatility being greater.

 

Source: FE Research

The team also found that only 17 managers out of 204 in the IA UK All Companies sector hold 30 stocks or less, with the average fund holding 52.5 stocks.

This contrasts with the recommendations of various studies, which suggest that maximum portfolio performance and indeed diversification is achieved through holding between 25 and 30 stocks.

Does this mean that a majority of fund managers are missing out on returns or does it mean that a comparatively small number of funds could be putting investors’ capital at risk?

Ryan Hughes (pictured), fund manager at Apollo Multi Asset Management, said: “The crucial question is: what is risk?”

“Risk means different things to different people. In our industry we work in a world of relative risk where we think being risky is not being close to the benchmark, because that affects our return against the benchmark. If you’re an end investor risk to you is losing real money. You don’t care what the benchmark is doing and what the fund manager has done, if they’re both down, they’ve done a bad job.”

“Having come from a private client background I’m very much focused on absolute risk because you’re dealing with end point clients and their real money and they only ever cared about whether you were losing them money.”


“As such, I’m very much a fan of concentrated portfolios. We look for those managers that really are prepared to move away from the benchmark and they typically hold concentrated portfolios. I think that right now, in this type of market where people aren’t really sure where the world is going and markets are essentially trading sideways, you need to find managers that are prepared to be different to the benchmark to give you a fighting chance of outperforming it.”

Colin McQueen, who manages the 25-stock Sanlam FOUR Stable Global Equity fund, agrees that risk has a different meaning to different investors and points out that the concept of diversification does, too.

For instance, while he says that he cannot possibly have exposure to every region and every sector across the globe, he does not want to and warns that this way of thinking about diversification in itself can prove to be a very high risk strategy.

“When we think about diversification, we’re trying to make sure we don’t have, say, five stocks that are all exposed to the same risk, so we don’t want 25 companies that are all going to suffer if the world suddenly decides that sugary drinks aren’t so good for you after all, or something happens in China, or the UK wants to exit the EU - we want to make sure that there’s no one common factor behind too many of the companies that would cause damage at the same time,” he said.

“We try to get diversification in that way but our main objective is simply to get businesses that are steadily growing their cash flow and with valuations on the cheap side.”

“Our priority when it comes to risk management is to make sure we understand what’s going on in the stocks and ensuring they really are high-quality, sleep-at-night companies, so we’re looking ideally for companies with free cash flow growth that grows in a relatively steady way every year.”

As such, the manager says that he is able to avoid entire areas of the market that he doesn’t like – such as banks or energy companies - while being able to protect capital.

Since the five crown-rated fund’s launch in 2013, it has provided a higher risk-adjusted return, a lower maximum drawdown (which measures the most potential money lost if bought and sold at the worst times) and a lower maximum loss (which measures the longest-running consecutive loss without making a gain) than its sector average.

It has also managed to double the performance of its peer group composite over the same time frame, providing a total return of 25.53 per cent.


Performance of fund vs sector since launch

 

Source: FE Analytics

It has, however, seen a greater level of annualised volatility than its average peer, although the manager says that holders of concentrated funds should adopt more of a patient, long-term view.

“We’re less concerned about day-to-day volatility in markets than we are with trying to deliver some resilience in the fund,” McQueen said. “If we go through tough periods in the economy or tough periods in markets, we want the fund to hold its value better than the average in the market and come through that in a more resilient way.”

Charles Younes, research manager at FE, says that concentrated funds do tend to have higher annualised volatility than their broader-based peers.

He points out that, when looking at the UK equity space, many managers will hold an ‘original’ and a concentrated fund with the same mandate and says that the best ideas funds often outperform because of the excess active risk they take.

“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. Maximum drawdown is also higher,” he said.

“It’s interesting that while the IA UK All Companies 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.”

ALT_TAG

Funds

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.