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Are many portfolios becoming too diversified?

24 October 2016

In the first of two articles, Lazard Asset Management’s Martin Flood explains why investors might have started to suffer from ‘over-diversification’.

By Martin Flood ,

Lazard Asset Management

Many famous investors such as Warren Buffett, George Soros, Bill Ackman, and Martin Whitman have created wealth through employing concentrated strategies. Yet, such a technique is contradictory to Modern Portfolio Theory (MPT), which stresses diversification as a risk-reducer.

Due to the popularity of the MPT by many in the investment community, there is a widely held belief that diversification is the key to successful investing. However, we feel that the goal of diversification is often taken to extremes and, at times, some managers have exchanged traditional risk control for returns. We believe that many investors would be better served by using more concentrated portfolios, which allow portfolio managers to invest only in their best ideas and focus on stock picking.

While it is sometimes difficult to identify concentrated managers as they do not exist in a defined universe and as the number of investments in their portfolios vary by opportunity set and manager—what identifies a concentrated portfolio is that stock selection is based on the manager’s level of conviction, not just for portfolio diversification.

 

Evidence from empirical studies

One case against the traditional idea of diversification is made in a working paper, Diversification versus Concentration …and the Winner is? (Yeung et al. 2012).

In this paper, the authors highlight the finding that there is a trade-off between diversification and returns. The study argues that fund managers often fail to leverage their own stock-picking skills when constructing diversified portfolios.

To make this claim, the authors examined over 4,700 diversified US equity mutual funds (defined by the authors as mutual funds with 30 or more stocks) with different styles, asset levels, and client bases. Using quarterly data from 1999 to 2009, the authors created concentrated portfolios by measuring the active weights of each diversified mutual fund, and then sorting the active weights from largest to smallest.

Concentrated portfolios were then built by using the largest active weights, which the authors interpreted as the fund manager’s highest conviction stocks. The concentrated portfolios ranged from five stocks (top 5 active weights) to 30 stocks (top 30 active weights) and the position sizes were then equal and conviction weighted.

The results of the conviction-weighted method, in which more weight was attributed to larger active weights, are displayed in the following table. The findings show that the absolute returns from the concentrated portfolios outperformed the diversified funds from which they were derived as well as their corresponding benchmarks. Additionally, the performance of the concentrated funds improved as they became more concentrated.

 

Source: Lazard Asset Management

The table also displays that while the standard deviation (a measure of the dispersion of returns which is generally used as an estimate of risk) of the concentrated portfolios increased as the number of holdings declined, so did the corresponding Sharpe ratio (the excess return over the risk-free rate per unit of standard deviation), meaning investors would receive increasingly more return per unit of additional risk taken by investing in a more concentrated portfolio.

Another interesting takeaway is that while standard deviation increased as the portfolios became more concentrated, at the 25 to 30 holdings range the standard deviations remained very close to that of the diversified portfolio.


Next, the authors measured the excess returns, historical tracking error (which measures the standard deviation of excess returns), and information ratio (a metric which is computed by dividing excess returns by tracking error, and which measures the historical consistency with which a strategy exceeds its benchmark) of the concentrated portfolios relative to the actual diversified funds they represented and to their corresponding benchmarks.

The next table displays that excess return, tracking error, and information ratio all increased the more concentrated a portfolio became. These findings suggest that many managers have good stock-selection skills as their top ideas tend to outperform, and with more consistency than more diversified portfolios as evidenced by the higher information ratios.

The study contained samples from value, growth, and style neutral funds, which is important as the authors wanted to evaluate whether their results were skewed by style. However, the results revealed that concentrated portfolios delivered favourable risk-adjusted performance across all styles as well as style-neutral funds.

 

Source: Lazard Asset Management

The study also concludes that by attempting to diversify holdings and perhaps move toward ideas which are not the portfolio manager’s top picks, performance suffers.

According to the authors: “These findings are basically good news for the professional managers who have long been criticised for their performance. The evidence suggests that they are actually good at what they spend most of their time doing, selecting stocks. The problem is that they are stripped of this edge due to having to depart from their stock preferences in the interests of diversification and risk-control. This is not to downplay the importance for investors of running a diversified portfolio across all of its investments but it does question the current practice of requiring a high degree of diversification of individual managers.”

In our view, since portfolio managers may be penalised for exposing investors to idiosyncratic risk, the desire for diversification among many investors and the investment community may cause managers to hold some stocks not because they will likely increase returns, but simply because these stocks are perceived to reduce overall portfolio volatility.

In another study, Best Ideas, the authors Cohen, Polk, and Silli (2010) conducted a similar exercise. In this analysis, which used data from 1984 through 2007, the authors utilised different methods to identify the best ideas in US equity mutual funds, and then evaluated the performance of these top ideas.

The authors found that portfolios’ best ideas “not only generate[d] statistically and economically significant risk-adjusted returns over time but they also systematically outperform[ed] the rest of the positions in managers’ portfolios.”

Outperformance of best ideas was found across benchmarks, risk models, and best idea definitions. While the amount of outperformance varied by best idea definition, the primary tests revealed outperformance ranging from 1.2 per cent to 2.6 per cent each quarter.


The analysis also suggested that the outperformance of concentrated strategies is sustainable, as outperformance did not typically mean-revert over the subsequent year. According to the authors, “We show that under realistic assumptions (e.g., investors put only a modest fraction of their assets into a particular managed fund), investors can gain substantially if managers choose less-diversified portfolios that tilt more towards their best ideas.”

Similar to the study by Yeung, et al., the authors also argue that the largely reported poor performance of the mutual fund universe is not due to stock-selection skills, but rather institutional factors which encourage managers to overdiversify in order to avoid idiosyncratic risk.

The authors argue: “Though of course managers are risk averse, investors appear to judge funds irrationally by measures such as Sharpe ratio. Both of these measures penalize idiosyncratic volatility, which is not truly appropriate in a portfolio context.”

Another interesting finding in the study is that over the 24-year review period, almost 62 per cent of best ideas were only considered as such by one manager at a time. Fewer than 18 per cent of best ideas were held by two managers at a time, and a best idea was in more than five funds less than 7 per cent of the time, suggesting that, in general, views regarding a stock as a best idea are largely independent across managers. This finding argues against the efficient market hypothesis, as varied style- and market cap-focused managers were able to exploit different types of best ideas.

 

Source: Lazard Asset Management

While not as sophisticated as the analysis described thus far, we conducted a study in which we were able to confirm the outperformance of more concentrated institutional mandates by examining separate account data in eVestment.

We grouped actively managed strategies in the US Large Cap Core universe into concentrated strategies (which we defined as those with 30 holdings or less) and diversified strategies (which we defined as those with greater than 30 holdings). We then measured the average 3-year and 5-year rolling returns of the concentrated and diversified manager groups, as well as the S&P 500 Index over the last 15 years. We found that concentrated managers outperformed both diversified managers and the index, as shown above.

To extend beyond US-based investments, we conducted the same test on the Global and EAFE Large Cap Core universes. Due to data availability, we could only conduct such tests over the last 10 years.

In these instances, we defined concentrated managers as those with less than 50 holdings due to the larger opportunity sets. We found extremely similar results in these tests, with concentrated managers outperforming diversified managers as well as the corresponding indices.

Martin Flood is a director, portfolio manager and analyst at Lazard Asset Management. The views expressed above are his own and should not be taken as investment advice.

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