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Do Concentrated Funds Outperform?

Alex Bryan, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Do concentrated strategies tend to outperform? Joining me to share some research on this topic is Alex Bryan. He is Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's talk about concentrated strategies. I think many investors understand that if a fund is able to put most of its assets in the manager's highest-conviction ideas, it should offer some ability to outperform. What would cause a fund that is concentrated to underperform?

Bryan: Historically, a small minority of stocks have really driven most of the market's performance. So, if you think about increasing concentration and owning fewer stocks or parking more of your assets in a smaller number of stocks, that actually increases the likelihood that you might miss out on the handful of the stocks that really drive the market's return. So, that opportunity cost of missing out on the market's big winners can offset the benefit of avoiding its many losers. So, I think that's important to keep in mind.

Benz: So, even if you had a more diffuse portfolio, you might not be able to benefit quite as much from those winners but at least you might have some of them, or your odds are better of having some of them?

Bryan: That's right. And remember, there's no limit on upside. So, some of those big winners can return 10 times what you put into them. So, even if they are a small part of the portfolio, they can still help. If you miss out on those stocks, it really can hurt you quite a bit.

Benz: So, let's take a look at your research. You examined whether more-concentrated portfolios have a propensity to outperform. What did you find when you looked back on the research?

Bryan: So, I basically looked at several different Morningstar Categories and then ranked all active managers based on the percentage of assets parked in their top 10 holdings and then kind of grouped them into quartiles. And I basically found that there really wasn't any significant link between portfolio concentration and performance. Whether you measure that based on average returns or based on the probability of beating a category benchmark, there really wasn't a big difference between the most concentrated and the least concentrated funds.

Benz: So, for investors who intuitively like the idea of being in a more concentrated portfolio because they think that it is maybe more active and therefore the manager has a better shot at beating the fund's benchmark, [that's] not necessarily revealed in the data.

Bryan: That's correct. So, the idea that a more highly concentrated portfolio leads to better performance, that's really a myth and that just doesn't bear out in the data.

Benz: Let's talk about one area where there is a pretty strong correlation and that is with conviction and higher fees. You actually found that funds that are more concentrated do tend to charge more. A, why is that, and B, what sort of link did you find there?

Bryan: I think it's important to kind of clarify. So, the research that I did for the most part focused on gross returns which controls for differences in fees. So, with gross returns there wasn't a link between concentration and performance. But if you look at net-of-fee performance, more highly concentrated managers tend to charge more. So, they would look worse net of fees. And the reason that they charge more is because I think there is this misconception within the industry that more highly concentrated portfolios have a greater chance of recouping their active fees because they are really focusing on their better ideas. They look different from the benchmark, so they can afford to charge higher fees. But the data suggests that really isn't the case. Highly concentrated funds really shouldn't be able to justify their high fees. And net of fees, they certainly have a higher hurdle to overcome, but there isn't really a lot of evidence that they are able to do so.

Benz: One takeaway though for you when you examine the data is that investors should still pay attention to concentration. If I'm selecting an actively managed fund, I should still pay attention to how many holdings are in the portfolio. Why would that be important?

Bryan: The risk in manager selection actually increases with portfolio concentration. So, while we didn't find a link on average between performance and concentration, the dispersion of potential outcomes increases with portfolio concentration. So, really highly concentrated managers can miss the mark by a really, really wide range. But they could also outperform by a wide range. So, you do have a lot of risk there in terms of manager selection. The cost of choosing a bad manager is greater when you are going with the concentrated funds. So, it's really important to have a lot of conviction if you are going to invest with a really highly concentrated manager.

I think the other point to remember is that more highly concentrated portfolios tend to have greater exposure to firm-specific risk, and on average, that's not well-compensated. So, again, you really want to keep an eye on risk and make sure that the manager that you hire is taking adequate steps to try to manage that risk that comes with concentration.

Benz: Alex, really interesting research. Thank you so much for being here to share it with us.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.