Is concentration the new diversification?

Medalist fund manager Virginia Au argues that the constraint of finding good investments, and the paucity of time, make concentration a good strategy

Ruth Saldanha 8 April, 2019 | 2:00PM

A major truism, both in investing and in life, is that you should not put all your eggs in one basket, meaning it is important to diversify. But sometimes putting your eggs in just a few baskets can work out best.

In the recent past, we’ve talked about how diversification, as traditionally understood, is a myth that works the least when you need it the most. In some cases, though an investor might feel diversified, it is possible they are not diversified at all.

For example, if an investor were to have a portfolio that consisted only of the S&P/TSX Composite index, they hold over 200 stocks. However, in terms of sectors, financials account for 33% and energy accounts for 18%. These two sectors alone account for half of the TSX. Not too diversified.

To make a portfolio that holds steady through bad markets and outperforms in good ones, investors must extend their notion of diversification and, in many cases, go beyond it, we said, and offered nine ways to diversify.

However, some managers argue that perhaps concentration is better than diversification.

“There are definitely a lot of benefits to diversification. But at a certain point it starts working against you,” says Virginia Au, vice president and portfolio manager at Invesco. She identifies two main issues with over-diversification – the constraint of finding good investments, and the paucity of time.

“Not every stock is undervalued, and as a stock picker, you obviously invest in the best idea first and so on. At a certain point, the return on new investment will diminish and you are essentially diluting your best ideas,” she explains.

She also points out that it takes time to truly understand a company and what you are buying. “You risk spreading your resources too thin and making investment decisions based on superficial reasons. But if you were to suggest putting more people and resource in this process to counter the time constraint, you still go back to issue #1 where there are only a limited number of attractive investments at any given time”, Au says.

As a result, Au uses concentration as a strategy, instead of diversification, and lists three benefits of concentration. First, better information usually generates better returns, so a concentrated fund allows the fund managers to conduct extensive research and understand the intricacies of the business in order to take advantage of mispricings in the market.

Second, by limiting the number of holdings, the fund managers are setting a higher hurdle rate for investment quality and return. “Managers can be more discriminating, avoiding stocks or sectors that are not value-added and focus on a tighter group of companies that meet their strict criteria,” she says.

And finally, she points to costs, an important factor in deciding where to invest. “With low-cost ETFs, there is simply no need for an active manager to construct a portfolio with a large number of holdings that mimics the benchmark,” she says.

An active manager's goal is to outperform the index, so if all a manager does is mimic the benchmark, it's hard for anyone to outperform.

So how does Au define concentration?

“I looked at the Morningstar database of over 1500 equity mutual funds available in Canada and saw that the average number of holdings is 96 stocks. That's a lot of investments and decisions in one fund. This means the majority of the funds available in the marketplace are not concentrated funds,” she said.

She points out that the problem of over-diversification magnifies when you consider that a unitholder might own multiple funds in their portfolios. “I think a fund with around 50 stocks makes sense for focusing on the best ideas. Numerous academic studies show holding 20-50 stocks is enough to reduce unsystematic risk, and limiting the number of stocks allows us to cherry pick strong businesses at an attractive price,” she says.

But speaking of risks, doesn’t over-concentration also lead to greater risk, basically putting all eggs into one basket?

“If your definition of risk is the deviation between the return of your fund and the benchmark on a quarterly, or yearly basis, then absolutely. But this would be risky because you have zero tolerance for both underperforming or outperforming the benchmark,” Au says, pointing out that you can't beat the market if you don't deviate from it.

She explains that for an investor, if your aim is for long term outperformance vs. the market, then active management and a concentrated fund is the better strategy. You will see a more uneven performance, especially in the short term because a concentrated portfolio may have little or no exposure to certain sectors. “Consequently, if that sector is "hot", then the fund may lag its benchmark for a period. A concentrated portfolio will reflect investor irrationality because the movement of a single stock in apositive or negative direction is based on rational or irrational investor behaviour,” she says.

To de-risk from too much concentration, Au recommends two options. The first option is that investors take a single concentrated fund and pair it with a low-cost ETF to boost portfolio performance potential. The second is to group several concentrated funds together to replace a highly diversified fund.

For her funds, Au focuses on the individual companies, and believes that the value of a business is grounded in fundamentals, though the market may under or over estimate that value from time to time. Because of this, she believes that managers need a strong understanding of what and how businesses do better than their competitors.

“And then, we look at how much this company is worth over the next five years. This allows us to overlook short-term fluctuations because the market tends to latch on to what happens in the next quarter and often overreacts. Our patient approach allows us to focus on the value a company can generate over the long term,” she says.

Au manages the bronze-rated Invesco Global Small Companies fund and the silver-rated Invesco US Small Companies Fund. The Global Small Companies fund owns 40 stocks, while the US Small Companies fund owns 28 stocks.

Another way to check for active managers is looking at the Active Share score, which measures the percentage of a fund's holdings that differs from the benchmark index. This score is available on Morningstar Direct. A score close to 100% means the mutual fund's holdings are very different than the index and a score below 60% is considered a closet indexer. This is important because you don't want to pay active management fees for ETF performance.

“For both the Invesco US and Global Small Companies Funds, we have over 99% active share, and in general, having high conviction and being true active managers is the backbone of our investment philosophy”, she says.

The turnover for the Invesco US Small Companies is 17% and for Invesco Global Small Companies it's 26%. The funds have an average holding period of 4-7 years.

About Author

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca