Connolly (pictured), says managers who are benchmark-agnostic and maintain a smaller portfolio of best ideas generally beat their peers over the long-term. "We always want our clients to have a diverse portfolio that is spread across different asset classes and within that in different sectors," he said.
"That can be achieved by using individual managers who run punchy funds and pay little or no attention to any one benchmark. We believe that it is the fund managers who don’t use a benchmark who are likely to outperform in the long-run."
"If managers stick closely to a benchmark, there is a solid case for using passive funds instead. We would advise using pure high-conviction fund managers to build a diverse portfolio," he said.
Connolly cites BlackRock UK Special Situations, run by FE Alpha Manager Richard Plackett as an example.
The fund is top quartile over three, five and 10 years, making 65.85 per cent over the past half-decade compared with 40.84 per cent from the sector average.
Performance of fund vs sector over 5yrs
Source: FE Analytics
Plackett’s fund is a concentrated portfolio, investing 62 per cent in its top-20 holdings.
Richard Troue, investment analyst at Hargreaves Lansdown, says that it is not as simple as Connolly suggests, and that a diversified fund is preferable in many areas of the market.
"On the whole, for the major developed equity markets in the likes of the UK, US, Japan, Europe and for some of the more developed emerging markets, we prefer a higher-conviction approach," he said.
"As they are larger, more liquid markets, we would like a portfolio of 30 to 50 best ideas. It means the highest-conviction stocks can really contribute."
Troue (pictured) adds that a more diverse portfolio is more appropriate for the less liquid markets such as emerging markets and smaller companies.
"You want managers in those areas to spread risk across their assets and a stock list of around 50 to 100 holdings, or even more in some circumstances."
"Obviously, the advantage of a more diversified portfolio is that the manager can spread risk and does not have to be too reliant on a small number of companies," he added. "By having a greater number of stocks it means the manager can also spread his exposure to different area of the market within the portfolio."
However, Troue warns that over-diversification can be just as damaging to a portfolio as none at all.
"It can mean that a manager doesn’t hold enough of one stock to contribute meaningful returns. For instance, if a manager only has 0.3 per cent exposure, the fund won’t perform as well as one with 3 per cent."
"Another risk of excessive diversification is that by holding too many stocks, the manager won’t really be able to analyse their fund in enough depth. Therefore they won’t know enough about a company as they probably should do."
"The disadvantages and advantages are vice versa for a high-conviction manager, as they could be overly reliant on too few stocks," he added.
FE Alpha Manager Giles Hargreave’s Marlborough Special Situations, which invests in smaller UK companies for growth, is one of the most successful and best-known diversified funds.
It comprises 244 individual holdings, with the top-10 accounting for just 13.3 per cent of the £578m portfolio.
Troue says that equity income is another area of the market in which investors should have a diverse spread instead of relying too heavily on one name.
The dangers were highlighted during the Gulf of Mexico oil spill, when too many investors held BP when it had to cut its dividend.
"It is absolutely something that investors need to be aware of," Troue continued.
"There are clearly advantages of a single fund that is a bit more diversified and it means their yield is not dependent on just two or three stocks."
"However, some managers are very good at it so investors may want to spread the risk themselves. If they were to build a portfolio with the likes of Neil Woodford, you get a manager who focuses on larger companies in the pharmaceutical and tobacco sectors."
"However, he might have to cut his yield if those areas were to struggle."
FE Alpha Manager Neil Woodford’s five crown-rated Invesco Perpetual High Income fund has 112 holdings.
The manager has strong positions in some of his biggest holdings, however. AstraZeneca and GlaxoSmithKline make up 8.53 and 8.23 per cent of the fund, respectively.
According to FE Analytics, Invesco Perpetual High Income is yielding 3.31 per cent and has returned 260.69 per cent over 10 years.
This beats both the FTSE All Share and the IMA UK Equity Income sector, which have returned 158.24 per cent and 148.21 per cent, respectively.
Performance of fund vs sector and index over 10yrs
Source: FE Analytics
Troue added: "You could also hold something like Marlborough Multi Cap Income which invests in entirely different sectors."
"The fund doesn’t hold the more traditional defensive names, but has exposure to economically sensitive stocks and cyclical names along with small and mid cap companies."
Marlborough Multi Cap Income is run by FE Alpha Manager Giles Hargreave and Siddarth Chand Lall. It has 137 holdings and is yielding 3.92 per cent.
Hargreave and Chand Lall have 76 per cent of the fund in companies with less than £1bn in AUM.
In the next two articles, FE Trustnet will look into five of the best high-conviction managers and five of the best with a more diversified approach.