Investors who choose to invest actively do so to harness the potential for alpha or outperformance. In order to mitigate the risk of underperformance, investors will usually construct a portfolio of active managers.
The next step is which managers? For investors comfortable with active management, concentrated products (over diversified products) are worthy of consideration as these provide a greater chance of delivering that much sought-after alpha.
This article explores concentrated equity products further.
Richard Grinold and Ronald Kahn, authors of the book Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Selecting Superior Returns and Controlling Risk showed that a number of factors influence the information ratio. These include a) the skill of the forecaster, b) the number of independent forecasts made in the product and c) the level of implementation efficiency in converting these forecasts into allocations within the product. These factors, taken together, suggest that a diversified product would produce a higher information ratio than a concentrated product, but would not necessarily outperform it.
While Grinold and Kahn’s thesis makes some sense, some of their simplifying assumptions could be challenged. Real-world evidence suggests that these simplifying assumptions are unrealistic—and lead to an overly favourable view of diversified portfolios relative to their concentrated counterparts.
In Figure 1, two investors, Don and Carl, invest only in equities. They split their assets equally between the same two skilled managers, ABC Investors and DEF Partners. The only difference is that Don uses the diversified products of these managers, while Carl uses their concentrated products.
Each product has the same benchmark, which reflects the broad equity market. The correlation between the excess returns of ABC and DEF is 0.2, whether for diversified or concentrated products.
We expect the concentrated products to have double the excess returns and triple the tracking error compared to the diversified products.
Given these values, it would lead an investor to favour Don’s portfolio of diversified products, with its better information ratio (0.43 versus 0.29). But what if we look at the same portfolio in a different way? Let’s assume that equities return 5% annually, with a variability of 15% per year and with no correlation to the excess returns of the managers. Figure 2 shows the impact on the overall ratio between expected return and risk.
Using this measure, we expect Carl’s concentrated products to perform better than Don’s diversified products. The higher excess return and tracking error of the active products increases expected total return far more than it increases total risk. That is particularly true for the concentrated products. This finding illustrates why many investors use concentrated rather than diversified equity products.
Another reason for favouring concentrated approaches relies less on theory and more on common sense.
If you think that an equity manager is skilled, then you should want its best ideas into your portfolio.
In a world of uncertainty and imperfect managers, though, you do not want your best manager to hold just a one-stock portfolio. Instead, you want some diversity.
You should let your best manager put only its best ideas into your portfolio until the manager’s conviction in its next-best stock idea wanes. After this, you would then move on to the second-best manager and get its top ideas. This process should be repeated until any more diversity unduly dilutes expected outperformance.
For example, consider two equally weighted portfolios that both seek to beat the S&P 500 Index. The first portfolio is concentrated and holds 20 stocks, each at a 5% weighting. The other portfolio is diversified and holds 1% in each of 100 stocks. To hold these long positions, each portfolio has explicit or implicit underweight positions in the remaining stocks in the index.
However, the size of the average active bet is about five times larger with the concentrated portfolio than with the diversified portfolio.
Any stock selection edge from the concentrated manager, therefore, will be magnified relative to the outcome of the diversified manager.
Many managers have particular expertise in certain pockets of the market. In these cases, the active bets of a concentrated approach would extract more value for the investor than those of a diversified approach.
Concentrated equity portfolios, while producing better alpha, are more governance-intensive than diversified portfolios. Investors should assess their governance capability before changing their manager structure.