Too many eggs in investment baskets

(Published in the South China Morning Post on 17 September 2006)

Everyone knows that diversification reduces risk. Except, of course, when it doesn't. It took the world some time to notice diversification was generally bad for conglomerates, and these inexpert, overstuffed dinosaurs are gradually becoming extinct.

Why? Because it is improbable that one management team will be the best manager of a wide range of assets in a wide range of industries. We all know that about industry, but often find it harder to accept in our own financial markets.

You might think that this column is going to look at why one shouldn't buy into chaebol and conglomerates. But I have a simpler point to make. Last month I looked at why the better mutual funds mostly keep their stocks for the long term. Today, I suggest that there is also a relationship between these good long-term performers and their high portfolio concentration. A portfolio with fewer holdings tends to do better than large shallow baskets of stocks.

Again, this can be explained in terms of the psychology of the fund manager. A good fund manager needs to deploy the same courage in selectively choosing a stock as he does in holding it for the long term. The courage necessary to turn expert views into substantial profits is, however, a rare quality.

In his 1973 classic, The Intelligent Investor, Benjamin Graham points to the experience of IBM stock in the 1960s. The renowned Columbia University economist writes that "smart investors would long ago have recognised the great growth possibilities of IBM", but that "the combination of [IBM's] high price and the impossibility of being certain about its rate of growth prevented [investment funds] from having more than, say, 3 per cent of their funds in this wonderful performer".

Typical mutual funds are highly diversified, holding more than 100 stocks. That is because, in addition to lacking conviction in their own analysis, they have one eye on keeping up with a benchmark index. Such behaviour is counterproductive.

The majority of actively managed diversified funds don't even match the index, because they have too many holdings to keep track of effectively.

Furthermore, their lack of knowledge in each of their individual holdings means that they are more likely to bail out during a wobble, resulting in higher turnover, which as I pointed out last month, also cuts into a fund's performance.

So the potential for good fund performance increases by holding fewer stocks. There are of course exceptions, but around 70 per cent of mutual funds under perform their benchmark.

The above phenomenon is actually founded on the basic observation that the chance of an investment decision contributing positively to a fund's performance is proportional to the amount of time spent on making - and monitoring - that decision. Since there are only so many hours in the day, a fund manager with lots of holdings is going to spend less time on each decision and thus get a smaller proportion of them correct.

Of course, there is a point at which concentration starts to weaken a fund's risk-return profile – a one-stock portfolio is clearly a bad idea - but there is an optimal level to aim for. The graphic suggests that investment either in an index fund or, if you believe in active management, one with a high degree of concentration are the rational choices. Anything in between just doesn't make sense.

How do we define the optimum portfolio size?

Generalised graphics can't tell us, for it is defined by the qualitative characteristics of the fund manager. The answer is not 18 or 26, but simply: what range of stocks can that manager understand to a degree of aggressive confidence? The intuitive answer is that the perfect fund manager will be able to understand a wide range of stock. In the real world, the key is the inverse: the perfect fund manager is the one who accepts what he doesn't know enough about, and chooses ruthlessly to exclude it.

For the investors seeking out highly focused fund managers, the problem is that the large fund companies do not tend to offer highly concentrated mutual funds since their size forces them into buying many different stocks. Their very bulk works against them.

One of the most concentrated large fund management houses is the Scotland-based Aberdeen Asset Management - which has US$130 billion under management — and even they have around 50 holdings in their regional fund.

That is why highly concentrated, funds will remain a niche product and, therefore, the realm of the boutique managers.

One such fund is Apollo Asia Fund, managed by Claire Barnes. It has around 23 holdings - the 12 largest representing nearly 80 per cent of the fund - and its net asset value has appreciated 14 times in the nine years since launch, equating to 35 per cent per annum.

However, the fund is generally closed to investors and has been turning away most subscriptions since early 2003, so as to restrain its size and maintain flexibility.

Portfolio management is a little like juggling. To keep an eye on your job and perform impressively it is advisable to throw fewer balls, higher.