Best Ideas Versus Overly Diversified
- Holding 20 issues in a portfolio is best practice. A typical stock fund holds more than 120 issues
- The issue is twofold: 1) too much money under management, and 2) an aversion to generating performance below the benchmark
- More than $15 trillion is invested in mutual funds today
Many investment professionals advise clients to diversify in order to manage uncertainty of returns. Often the concept of diversification is lost by too much diversification.
Webster’s dictionary defines diversify as follows: to balance (as an investment portfolio) defensively by dividing funds among securities of different industries or of different classes.
Academic studies indicate that the amount of uncertainty that can be “diversified away” is effectively and practically realized when a portfolio holds between 15 and 25 securities of different industries or different classes. Some diversification is good, too much is unproductive and simply diffuses intelligent effort and adds to the expense of managing an investment portfolio.
Billionaire investor Warren Buffett famously stated that, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
What follows is Milwaukee Private Wealth Management’s perspective on diversification.
The Issue
A focused portfolio of 20 securities has 5% weight/holding. A broadly diversified portfolio of 120 issues has 0.83% weight/holding.
When managing $250 million in equity capital, a five percent position would consist of $12.5 million of the fund’s capital. To avoid holding an oversized position in one company the fund may limit itself to holding less than five percent of the company’s total equity. The fund by definition can invest in a company with a market cap of $250 million or more. This leaves nearly 5,000 North American companies for the fund to consider for ownership.
On the other hand, if a fund manages $10 billion in equity capital – a modest amount of capital by today’s fund standards – and wishes to employ five percent of its capital in each holding (or $500 million) using the same guideline, the universe of available companies would be those with market capital over $10 billion. The fund reduces its available universe of companies to roughly 650.
| Fund Size | Number of 5% Holdings | Market Capitalization Limit | Universe of Stocks |
|---|---|---|---|
| $250 Million | 20 | $250 million | 4,830 |
| $10 Billion | 20 | $10 Billion | 658 |
Investors should expect their managed portfolio will outperform an unmanaged market index over time. Consequently every investment fund compares itself to a benchmark index.
Short term fund performance is difficult to forecast. Investors demanding and chasing after short time results have unknowingly caused a significant behavior bias by fund managers. If a fund performs exceptionally well over a short period it will capture substantial capital inflows. Since funds earn fees and other compensation based on the amount of capital managed, the prospect of capital inflows becomes economically attractive to the fund industry, which manages in excess of $15 trillion.
On the other hand, if a fund produces sub-index performance for several quarters or more, it is likely investors will withdraw capital. Consequently fund managers generally attempt to produce at least index matching results – not necessarily better, but definitely not much worse – with the goal of maintaining assets under management.
Evidence of this trend can be seen in the explosive growth of index or near index fund construction across the fund management industry. The explosion in index investing and the marketing of such investment strategies is impressive.
What Does This Mean?
As a result of these industry incentives and pressures, fund managers are discouraged from concentrating on just their very best ideas. To deviate could mean a loss of capital in the short run and possibly a loss of employment over the long run.
The most commonly tracked stock index is the S&P 500. This is a capital weighted index, meaning the weight of any stock in the index is proportionate to the size of the company in the marketplace. Apple and Exxon make up a disproportionately larger amount of the S&P than Urban Outfitters and Fossil Group.
It is difficult to identify a sizable mutual fund in which the top holdings don’t nearly match the holdings of its benchmark index. This phenomenon is referred to as “hugging your benchmark,” meaning the fund manager is simply attempting to provide added value by owning the same stocks in its benchmark index with modest variations. The uncertainty of underperforming and experiencing capital outflows outweighs the opportunity to provide outstanding long-term results – a classic human behavioral dilemma.
To further illustrate the problem, assume a hypothetical situation in which a fund manager has an unusual ability to select attractively valued stocks regardless of their index inclusion. The manager is asked for his best 20 investment ideas for inclusion in a portfolio – those ideas in which he has the highest level of confidence. His twentieth idea may not be quite as promising as his first or second idea, but still has a promising outlook. When then asked for his next one hundred ‘best ideas’ in order to round out the ‘average portfolio’ which holds 120 stocks, it is nearly certain that his 67th, 84th, or 120th pick will be far less promising than any of his top 20.
If a fund manager is a capable analyst, his investors will want only his best ideas in their portfolios in an effort to produce superior long-term returns. Unfortunately for most fund investors, the pressure to capture more assets demands funds increase their holdings, until alas, they become indexed or index like in nature.
There are exceptions to this, but it is a rare event when a fund closes its doors to new investors.
What To Do?
At Milwaukee Private Wealth Management, Inc. we believe patient, long-term focused investors who are willing to endure short periods of non-correlated results that deviate from the market index can achieve superior long-term results.
As many large funds have little or no direct contact with their customers, they are challenged to employ such a strategy without risk of capital outflows.
The reason a focused investment strategy – one in which a modest number of stocks are owned – works well is due in part to its contrarian strategy. Few funds are willing or able to employ such a strategy for reasons mentioned above.
If an investor owns a fund that holds several hundred securities he may conclude the funds objective is to simply match its benchmark, or, the investment manager is not particularly capable of analyzing companies and electing to hold his few best ideas, but rather, overly diversifying so no single position’s performance will significantly impact the fund’s return.
Long-term investors should seek investment managers willing to invest in a short list of companies in which they have a high level of confidence. This puts the investor in a position to earn more than market average returns. A modest incremental return compounded over a long period produces a surprisingly large difference.
Compounding capital at 7% vs 10% over 30 years:
$100,000 portfolio returning an average of 7% annually: $761,225
$100,000 portfolio returning an average of 10% annually: $1,744,940