- High conviction means high returns, right?
- Not when you fake it
- But low diversification does mean more risk
- Investment process is key
- Loads of new idea-generating data
The reason the Ideas Farm publishes lists of the highest-conviction holdings (or best ideas) of top fund managers is because of the evidence that the biggest bets of funds tend to perform best. Lower-conviction holdings, meanwhile, have been shown to detract from overall performance.
The finance industry has reacted to these findings from academia with a broad push to make funds more concentrated by reducing the number of holdings in portfolios. Seems sensible… or does it?
A recent report from FactSet-owned Cabot Investment Technology and JANA Investment Advisors claims that making funds more concentrated by diktat does not reliably improve performance. Indeed, the report’s authors say they have found many examples where reducing the number of portfolio holdings leads to an outperforming fund becoming an underperforming one. In particular, the report cites findings that managers often make worse buying decisions when pressured to hold fewer stocks. They also often struggle to adjust position sizes and waste energy trying to trade existing positions.
But why would fund managers become worse stockpickers when their funds are more concentrated? The answer may be because all those performance-sapping, low-conviction positions actually do something important for a fund manager’s decision-making process. Managers may need the security blanket of diversification in order to make bolder bets on big winners. To replicate that kind of emotional reassurance in a portfolio with fewer holdings, a solution would be to select individual stocks with more palatable risk profiles. Inevitably this would affect the stockpicking process.
Many large, top-performing positions may also have started out small and been scaled up as confidence in an investment case increased. If small positions are not allowed, the seed may never be sown of a future outperforming, overweight holding.
Professionals are not the only ones who struggle to understand the role of portfolio concentration in generating returns. Private investors get bombarded with stories about individuals and funds that have made knockout returns with super-concentrated portfolios. However, such stories are treacherously self-selecting.
Any decent-sized sample of randomly-generated, highly-concentrated portfolios can be expected to give rise to isolated stories of eye-popping returns. However, the value of concentration can only be properly assessed if the winners are seen alongside the losers and the also-rans.
When it comes to high-concentration portfolios, the big losers can be expected to be just as ghastly as winners are great. But our love of zero-to-hero narratives means we tend to only focus on the success stories. Well, maybe we also have time for the odd gloat at a cataclysmic that-would-never-happen-to-me disaster. Such narrow focus is very dangerous in a field such as investing where it is fiendishly hard to distinguish luck from skill when judging outcomes.
In the Cabot and JANA report, one case study is given of a manager who successfully achieved higher returns by increasing concentration. However, this was not based on an overnight change. It resulted from a deep and genuine understanding of the investment process that allowed the manager to gradually focus on fewer stocks; evolution, not revolution.
Both private and professional investors would do well to think deeply about the true merits of portfolio concentration based on their individual investment process, self-knowledge and level of experience. High-conviction can be a mark of success, but when the cart is put before the horse, it can create unwarranted and unforeseen risk.
Read more about Cabot and JANA’s research here.
Read why it pays to track fund managers’ best ideas here.