Although it is a commonly held view that funds with concentrated portfolios will outperform over the longer term – as active managers have the ability to generate more alpha by putting more of their assets into their best ideas – our study suggests that this has not been the case in recent years.
Our study shows that an equally weighted portfolio of the top-20 most diversified IMA UK Equity Income funds, in terms of the proportion of total assets weighted in their top-10 holdings, has returned 104.73 per cent over the last five years, beating the sector average by close to 10 percentage points.
The portfolio of the top-20 most concentrated equity income funds has returned 92.71 per cent, therefore underperforming against both its more diversified rival and the sector.
Performance of composite portfolios vs sector over 5yrs
Source: FE Analytics
This trend is prominent across other time periods and UK equity sectors.
According to FE Analytics, the most diversified funds in both the IMA UK All Companies and IMA UK Smaller Companies sectors have significantly beaten their more concentrated rivals over five years as well.
Concentrated funds in the three sectors have also all generally underperformed against their diversified peers over one and three years; the only exception is the IMA UK Smaller Companies sector over the last 12 months.
Source: FE Analytics
To make up the portfolios for the UK All Companies sector, we took the top and bottom 20 funds for portfolio concentration, while in the UK Smaller Companies sector we compared the 10 most concentrated funds with the least.
The study also revealed that funds within the IMA UK Equity Income sector that are more diversified, which include FE Alpha Manager Mark Barnett’s Invesco Perpetual UK Strategic Income fund and the five-crown rated PFS Chelverton UK Equity Income fund, have paid our more income over the last five years.
Diversified funds in the sector have delivered £317.73 worth of income on an initial £1,000 investment over the period, while the concentrated portfolio has paid out £306.73.
Within the UK Equity Income sector, 12 of the 20 most diversified funds have beaten the sector over a five year period.
Among the best performers have been the Chelverton fund, which has just 18 per cent of its assets weighted in its top-10, Standard Life UK Equity Income Unconstrained, which has 26 per cent, and Montanaro Equity Income, which has 34.1 per cent.
In the concentrated portfolio, only five out of the 20 funds have managed to beat the sector.
While it includes top-performers such as the five-crown rated Unicorn UK Income and Threadneedle UK Equity Alpha Income portfolios, highly concentrated funds such as Elite Charteris Premium Income, UBS UK Equity Income and BlackRock UK Income have all delivered bottom-quartile returns.
The outperformance of small and mid caps over the last five years relative to FTSE 100 stocks could be one of the major factors that has affected the results in the IMA UK All Companies sector.
Performance of indices over 5yrs
Source: FE Analytics
Our data shows that the most diversified All Companies funds more often than not have a small-to-mid cap bias, with the likes of Cavendish Opportunities, Barclays Lower Cap and Threadneedle UK Mid 250 all featuring on the list.
All three of those funds have delivered market-beating returns over the past five years and have been major beneficiaries of the mid and small cap tailwind.
While the large majority of concentrated UK growth funds have outperformed the market over five years, they are predominantly large cap portfolios. They include the likes of CF Lindsell Train UK Equity, Invesco Perpetual High Income and JOHCM UK Opportunities.
All three of those funds have more than 50 per cent invested in their top-10, with the Lindsell Train fund the standout high-conviction portfolio, at 71 per cent.
In the UK Smaller Companies sector, one of the major reasons why the portfolio of concentrated funds has underperformed is because SF Webb Capital Smaller Companies – which has 52 per cent of its assets locked in its top 10 – has lost a staggering 40 per cent over five years.
The sector and its Numis Extended Smaller Companies ex IT benchmark have both returned more than 130 per cent over that time.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
The diversified portfolio of funds, on the other hand, has top quartile performers such as Giles Hargreaves' Marlborough Special Situations and Marlborough UK Micro Cap Growth funds, which both have less than 20 per cent invested in their top-10 holdings.
Rob Morgan (pictured), pensions and investment analyst at Charles Stanley Direct, says that the results of the study do come as a slight shock.
He says they show that investors need to drill down further when choosing a fund because managers who take a more concentrated approach and those that are more diversified can both outperform over the long-term.
“It’s a bit of a surprise, but it is also a bit of a generalisation,” Morgan said. “For instance, managers like Giles Hargreave have always held more than 100 stocks and have performed very, very well. Managers have different styles and being concentrated is a good way to add value. But it also means that your mistakes are costly and it is harder to control risk.”
“If you are going to run a concentrated portfolio, you have to be pretty good. Someone like Richard Buxton has performed well by pursuing that strategy, but then Anthony Bolton always had quite a broad portfolio when he ran Fidelity Special Situations.”
