Blogs & Comment

Do away with diversification

A new report argues that active managers fail to beat their benchmark because they're too diversified.

If you’ve seen one Michael-Lee Chin speech, you’ve seen them all. Not a talk goes by without the Canadian billionaire and lead manager of Manulife’s AIC advantage fund discussing how he turned $100 million worth of Mackenzie Financial stock into $400 million.

This morning, at the PROFIT 200 CEO Summit, the legendary investor told the story again. He made millions, which turned into billions, off of one stock; his AIC fund itself holds less than two-dozen companies. No matter how many times he gives a speech, and despite AIC’s ups and downs, the story remains the same—only buy companies you know and do away with diversification.

Lee-Chin’s narrow focus on financials is a big reason why he was able to make boatloads of money in the early 2000s. He could never grasp the concept of diversification, he says. “It’s impossible to understand 100 companies,” he said in his CEO Summit speech today. “Every person in the world should only own a few high quality businesses.”

His investment approach is vastly different from many other managers. Active managers—portfolio managers who pick stocks for a mutual fund—often develop portfolios with many companies, sometimes over 100. Lee-Chin’s theory is that over diversification is why so many fund managers have such difficulty beating their benchmark. (According to Russell Investments Canada, just 39% of Canadian large-cap managers beat the index in Q1 2011.)

Lee-Chin’s philosophy is shared by Scott Vincent, a managing partner at Baltimore’s Green River Asset Management, and author of the new report Is Portfolio Theory Harming Your Portfolio?

Scott argues that Modern Portfolio Theory—the idea that active investors can’t beat their benchmark and diversification is key—is failing because most portfolio managers own too many companies. They’re essentially building index-like portfolios instead of carefully choosing stocks.

The average number of holdings in a fund, he says, is up about 100% since 1980. “Some might call it ‘super-diversification’, while others apply the label ‘over-diversification,’” he writes in his report. He adds that in any given year, because of frequent turnover, managers could hold as many as 200 companies in a portfolio.

The problem with owning so many companies is that the fund starts to operate like an index. He accuses fund companies of running “closet index funds”, or funds that appear to be actively managed, but are no different than a benchmark-tracking portfolio.

“The actively managed equity fund industry has warped itself into something that closely resembles what it ought to be fighting against —the efficient, passive index fund,” he writes. “In so doing it has doomed itself to an inescapably unfavorable comparison with these highly efficient index funds minimizing the role of the ‘active manger.”

This hurts investors who pay high, active management fees, for, what Vincent says is “quasi-active management.”

Diversification may actually make a portfolio riskier, he explains, because fund managers are forced to buy companies they don’t fully understand. Instead they should, as Lee-Chin does, own a small basket of well-researched stocks.

“It may be that combining a group of securities hand-selected for their limited downside and high potential return, the skilled active manger with a relatively concentrated portfolio has greater potential to offer lower risk and higher returns than a fully diversified portfolio,” writes Vincent.

Another legendary investor, Warren Buffett, also thinks diversification doesn’t work. One of his most famous quotes is about the perils of owning too many stocks: “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”

Scott points out that Buffett also thinks diversification raises risk. “We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it,” Buffett has said.

While Scott doesn’t do his own research to find out if concentrated active managers beat the benchmark more frequently than mangers who run more index-like portfolios, he points to other studies that show narrowly focused managers who own between 10 and 60 stocks, and sometimes less, beat their benchmarks by 6.5% a year net of fees and expenses.

So what does this mean to you? Scott’s not saying investors should do away with diversification, but instead of buying one fund with 100 stocks, diversify by manager. “The individual investor can achieve greater success spreading money among talented mangers who have each limited diversification to the point where its costs are equal to its benefits,” he writes. “An individual investor’s tolerance for risk can be expressed by choice of manager as some concentrated funds are run conservatively while others accept more risk.”

While investment managers like Lee-Chin and Buffett have shown that a small portfolio of stocks can make money, there are still many people who argue that diversification is the less volatile way to invest. But Scott says to just look at some of the world’s wealthiest entrepreneurs. They made their money buy buying into concentrated opportunities, so why can’t you?

“Most of the wealth in the world has resulted from individual entrepreneurs using their judgment to invest in opportunities in a highly concentrated, even exclusive, fashion,” he writes. “Think about that for a moment.”

What do you think? Is it better to own many stocks or just a few? Let us know in the comments below.