Many active fund managers are pursuing a potentially risky strategy to compete with passive funds by shunning diversification and focusing on portfolios of fewer stocks, The Wall Street Journal reports. They are seeking to differentiate themselves further from the low-cost passive ETFs that have been outperforming a large, and growing, majority of active funds simply by tracking market indexes.

Moving towards more concentrated portfolios is an attempt to boost investment returns. However, this strategy seems to have backfired, as the most concentrated actively-managed funds are trailing not only the S&P 500 Index, but also their more diversified peers.

Key Takeaways

  • Actively-managed funds with small portfolios are growing in number.
  • Concentration is a strategy to improve performance.
  • However, this is increasing risk and producing worse returns.

Significance For Investors

The number of actively-managed U.S. stock funds with less than 35 holdings in their portfolios is nearly twice what it was at the beginning of 2009, and their assets under management (AUM) are almost three times as large, ending Oct. 2019 at about $161 billion, per analysis by Morningstar Direct cited by the Journal. These concentrated funds now represent over 9% of actively-managed U.S. stock funds, up from 7.6% at the start of 2009. This percentage has not doubled because the total universe of actively-managed funds has grown.

The theory behind concentrated portfolios is that these represent the very best investment ideas identified by their managers. Famed investors such as George Soros, John Paulson, and Warren Buffett are among those who favored this approach.

Buffett had this to say, in his 1993 Chair's Letter: “If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices--the businesses he understands best and that present the least risk, along with the greatest profit potential."

However, over the course of the current bull market, concentrated active funds with less than 35 stocks have produced an aggregate total return that is about 80 percentage points less than that for the S&P 500 Index. Among those holding 20 or fewer stocks, relative performance has been even worse. They have trailed the S&P 500 total return by 133 percentage points over the same period.

Some advocates for concentrated portfolios argue that they will do better in market selloffs than more diversified funds. “In the financial crisis you pretty quickly saw that it didn’t matter how many companies you owned, it really mattered how high-quality they were,” as Dan Davidowitz, a portfolio manager at Florida-based Polen Capital, told the Journal. His firm has AUM of almost $33 billion, largely in concentrated portfolios for its clients.

However, the same report notes that the results have been less than compelling in recent years. During the financial crisis of 2008, as well as during market pullbacks in 2011 and 2015, concentrated active funds with less than 35 stocks fell less than their more diversified peers, but more than the S&P 500. Amid the 2018 selloffs, they finally dropped by less than their diversified peers, but did worse than the S&P 500 once again.

Looking Ahead

“I believe it’s inevitable that if you fast forward 10 to 15 years, the bulk of surviving active strategies in developed markets will be high-concentration portfolios,” as Barry Gill, head of equities at UBS Asset Management, told the Journal. Investors who prefer concentrated funds “don’t think bull markets last forever, and they think there will be a time when stock pickers have an advantage,” adds Richard Cook, who oversees about $310 million in AUM at Alabama-based Cook & Bynum Capital Management.