There’s one rule of investing that professionals talk about time and time again: Diversify your investments. Well, rules are made to be broken. In some cases, it may make sense to limit your number of holdings. Typically, diversification helps reduce your risk, whereas concentration is more about increasing returns. But in any portfolio, there’s room for a bit of both.
That is, provided you have allocated your assets widely enough to suit your risk tolerance, owning just a few securities in markets you know well (for most of us, that means Canadian equities) will serve you better than broad exposure. The reason? The more you know about the stocks you hold, the better you’ll do.
Clemens Sialm, a professor of finance at the University of Texas, has published a number of papers on the effects of concentration. In one study comparing sector-specific funds, he found that the 10% of funds that concentrated on one industry—say, technology or utilities—outperformed the 10% of funds with the lowest exposure to any one sector by about 1.6 percentage points a year. When he looked at the entire fund universe, he discovered that the most sector-specific half of all funds returned 1.2% more than the rest.
Sialm also looked at the experience of individual investors who held just one or two stocks versus those who held three or more. The concentrated investors outperformed the people with numerous stocks by more than two percentage points a year. That performance gap doubled among households with more than US$100,000 in assets.
Sialm is not suggesting people sell all but two stocks—that would expose them to greater risk than they’re probably comfortable with. The point is that investors with just a few stocks tend to know those companies better, and that gives them an edge over their more diversified peers. “One of the reasons you would want to hold a concentrated portfolio is if you have superior information about the stocks,” he says.
The individuals in Sialm’s study who did best held small-cap stocks with head offices in their own city or region. That might seem odd, but the close proximity helped investors become intimately familiar with their holdings. They often read about them or knew people who worked there. “They were very confident in those stocks,” Sialm says. Holding a few Canadian companies you know and admire, therefore, might be a better long-term strategy than possessing a fund tracking the S&P/TSX composite index.
That’s what Kim Shannon, founder, president and chief investment officer of Sionna Investment Managers, has done. Shannon used to run large diversified funds—she was once a star manager at CI Financial—but she now manages portfolios that hold a smaller number of mostly Canadian stocks. This way, managers are able to execute their best ideas, she says, rather than creating a portfolio with some filler options along with their favoured names. Sionna’s funds don’t yet have a long enough track record to demonstrate whether the strategy works. The Sionna Opportunities Fund, Shannon’s most concentrated fund, with about 25 stocks, has only been around for 15 months, though it outperformed the S&P/TSX composite index by 5.8% in that time.
A more established fund of this type is Lazard Asset Management’s U.S. Equity Concentrated Portfolio, which holds about 20 names. Since its launch in September 2005, it’s delivered an 8.14% annualized return, compared with 7.87% for the S&P 500. Concentration “exploits the manager’s ability to focus on the competitive advantages of each business,” says Chris Blake, the Lazard fund’s manager. “When you have a small subset of names, you can be very homed in.”
Half the stocks in the fund have a weighting of 4.7% or more. Blake’s largest position is Advance Auto Parts (NYSE: AAP), which accounts for 10.4% of his portfolio. That could have a dramatic impact on returns if one of the heavily weighted companies goes south. But the stocks he deems most risky are the ones with the smallest positions. “I want the 10% position to be in something I can model out with more assurity,” he says.
He maintains that the fund is still diversified—not by sector, but in that each company does something different from the others. While it’s important not to lose sight of managing your risks, numerous studies suggest that a small basket of holdings—between 10 and 20 stocks—can achieve diversification nearly as well as an index fund. According to Blake, his fund has a standard deviation of 8.83%, barely more than the S&P 500.
Concentrated portfolios aren’t for everyone, cautions Russel Kinnel, Morningstar’s director of manager research. You can’t just pick any fund and expect higher returns. Ultimately, it comes down to the manager’s skill level. “The burden of proof is greater for a focused fund, as it’s trickier to balance the risks in a 20-stock portfolio than a 90-stock one,” he says.
A good manager of concentrated funds should have, first and foremost, a solid track record of outperformance. They should also be diversified within their portfolio, but that doesn’t mean having a sector-neutral fund. “You want them to have an awareness of the risks,” says Kinnel. “So there may be a balance from a sector standpoint but also from a high- and low-risk holdings perspective.” Look at how the fund did during periods of downturn, too; you need to ensure you can stomach the risk.
And that’s the rub. Many people prefer a widely dispersed portfolio because it will not experience the ups and downs of a narrowly focused one. To Kinnel, retirement savings might be better off in a larger fund, while any extra dollars could go into a concentrated basket of stocks. “Different funds fill different roles,” he says. “There’s nothing wrong with concentrated funds, but you need to appreciate that they’re different.”
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