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| Peter Hodson |
Do you ever get frustrated when you do a ton of work on something, and yet never get any actual benefit from the work you've put in? Most people would, which makes it all the more surprising when you realize that many portfolio managers do exactly that, day after day.
Let me explain: Most portfolio managers are a diligent crew, slaving over financial reports, meeting company
management, running models, interviewing analysts and so on. It takes a lot of effort to ensure that an investment
idea is appropriate for a portfolio, and no PM I know takes the job or their fiduciary responsibility lightly.
That's why it is surprising that, after all that effort, many PMs tread very lightly with their investment ideas, by just buying tiny positions in their investee companies, and having a portfolio of 100 or more names, rather than concentrating on their best investment ideas.
As a result, many portfolio managers take diversification to an extreme level, to their own detriment. Even though many PMs are CFAs as well, many often forget that part in the CFA course that shows that diversification benefits in a fund start to diminish after just 20 or so securities.
Don't just take my word for it -- in The Intelligent Investor, Benjamin Graham said the number of securities needed to diversify was between 10 and 30. Burton Malkiel wrote that 20 stocks would do it, in his classic book, A Random Walk Down Wall Street. But if you went to www.sedar.com
To examine the annual reports of many mutual funds, you might find 100, 200, 300, even 400 individual securities listed in funds. What gives? Are managers so scared of volatility that they excessively dilute the impact of their own research by making only tiny investments in their own ideas? Perhaps these managers have no confidence in their own stock-picking abilities to take larger positions. Perhaps it is easier to keep their jobs that way, by never being wrong -- by default -- on a large position.
I have no idea why, to tell you the truth, as I try and practise the exact opposite approach. I believe that if you like an investment idea enough, and you have done the proper amount of research on it, then you should make it a large position in your portfolio. If you do the right work on an investment idea, then you should be rewarded for it. Big time. In other words, if you don't like something for at least a 2% weighting in your fund, then you probably don't like it much at all. Why buy a half-percent weighting? Who can keep track of 200 positions anyway?
This idea might rile a few feathers, and certainly may go against the commonly held belief that any diversification is good. But it is not. The great Peter Lynch coined the term "diworsification" to highlight how he would avoid companies that diversified their businesses into something they knew nothing about, just for the sake of diversification. Coca-Cola branching off into shrimp farming years ago is the best example of diworsification in action. But diworsification works with mutual funds, too. Managers should, of course, stick to their expertise and avoid the tendency to add positions just for the sake of diversification. Volatility might be reduced, but at the cost of mediocre performance.
That's why it is surprising that, after all that effort, many PMs tread very lightly with their investment ideas, by just buying tiny positions in their investee companies, and having a portfolio of 100 or more names, rather than concentrating on their best investment ideas.
As a result, many portfolio managers take diversification to an extreme level, to their own detriment. Even though many PMs are CFAs as well, many often forget that part in the CFA course that shows that diversification benefits in a fund start to diminish after just 20 or so securities.
Don't just take my word for it -- in The Intelligent Investor, Benjamin Graham said the number of securities needed to diversify was between 10 and 30. Burton Malkiel wrote that 20 stocks would do it, in his classic book, A Random Walk Down Wall Street. But if you went to www.sedar.com
To examine the annual reports of many mutual funds, you might find 100, 200, 300, even 400 individual securities listed in funds. What gives? Are managers so scared of volatility that they excessively dilute the impact of their own research by making only tiny investments in their own ideas? Perhaps these managers have no confidence in their own stock-picking abilities to take larger positions. Perhaps it is easier to keep their jobs that way, by never being wrong -- by default -- on a large position.
I have no idea why, to tell you the truth, as I try and practise the exact opposite approach. I believe that if you like an investment idea enough, and you have done the proper amount of research on it, then you should make it a large position in your portfolio. If you do the right work on an investment idea, then you should be rewarded for it. Big time. In other words, if you don't like something for at least a 2% weighting in your fund, then you probably don't like it much at all. Why buy a half-percent weighting? Who can keep track of 200 positions anyway?
This idea might rile a few feathers, and certainly may go against the commonly held belief that any diversification is good. But it is not. The great Peter Lynch coined the term "diworsification" to highlight how he would avoid companies that diversified their businesses into something they knew nothing about, just for the sake of diversification. Coca-Cola branching off into shrimp farming years ago is the best example of diworsification in action. But diworsification works with mutual funds, too. Managers should, of course, stick to their expertise and avoid the tendency to add positions just for the sake of diversification. Volatility might be reduced, but at the cost of mediocre performance.
In the dot-com era, for example, in order to diversify, almost all the "value" managers decided to add "growth" companies to their portfolio, even though they weren't familiar with the growth style. These value managers wouldbuy companies trading at "only" 20 times revenue. We know how that worked out. The managers that stuck to their investment style survived the dot-com implosion the best.
As a firm believer in concentrated portfolios, whether by individual securities or investment sector, our firm is obviously biased. So again, don't take our word for it: There is a great study, available on our Web site at www.sprott.com, that highlights the benefits of not diversifying an investment portfolio. In the study, titled On the Industry Concentration of Actively Managed Mutual Funds, authors Marcin Kacperczyk, Clemens Sialm and Lu Zheng conclude "on average, more concentrated funds perform better after controlling for risk and style differences using various performance measures. This finding suggests that investment ability is more evident among managers who hold portfolios concentrated in a few industries."
The key point of the study is that, contrary to conventional wisdom, fund managers should not diversify but instead concentrate their portfolios if they believe some industries will outperform the overall market. If a manager believes they have "superior information" (note this is not insider information, but superior knowledge through extra effort and greater understanding), then they should concentrate their portfolios even more.
A radical thought, perhaps, but scanning the list of top performing funds over the past one, five and 10 years will show you that it works. Many of the best funds have either a smaller number of positions, or are extremely concentrated in just a few sectors.
How can this approach work for you? Well, for fund investors, keep it in mind. Have some -- but not too much -- diversification in your fund portfolio. Morningstar. com, for example, has shown that once you own seven mutual funds, adding another will help neither performance nor diversification. Perhaps the best approach might be to have just a few funds whose fund managers hold concentrated positions. If the funds you hold have dissimilar correlation to each other, there's a good chance you'll likely have enough diversification and decent investment performance.
Peter Hodson,CFA, Editor
Canadian MoneySaver
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