Private investors are often warned about the risks of running highly focused portfolios for the sake of investing heavily in just a handful of shares. For the average stock picker, getting the balance wrong between adequate diversification and high conviction can leave them hopelessly exposed if one of those shares goes on to collapse. In the case of smart money fund managers however, those that deliberately make big bets in a relatively concentrated portfolio have been found to be some of the industry’s best performers. So what is is about these high conviction managers that makes them so effective - and how can we take advantage?
Not all fund managers are equal
We wrote recently about some of the factors that make the actively managed fund industry such a duff deal for many investors. In a market that’s geared up to making a profit for itself first, and its customers second, so-called career risk means that it’s all too appealing for managers to weight their funds more heavily towards their benchmarks than their best ideas. In the worst cases, this means that some of them behave like quasi-tracker funds, performing in line with the market but still attracting high management fees.
Among the acres of research into the predictiveness and stock picking abilities of institutional money managers, there’s a general agreement that investment funds underperform. But dig a little deeper and you’ll find a hidden seam of active funds that can generate alpha by doing things differently. Among them are those that are prepared to make big bets in a much smaller number of companies than their peers. Rather than spreading their risk around a large portfolio and picking a few winners and a larger number of laggards, these confident few appear to be able to outperform from a smaller number of high conviction positions.
Picking the best stock pickers
In 2006 a team of US researchers (Baks et al.) studied fund industry data and found that concentrated managers outperformed their more broadly diversified peers by approximately 30 basis points each month, or around 4% annualised. After scrutinising their individual holdings they discovered that these focused managers excelled because their big bets outperformed the top holdings of more diversified funds. The findings suggest that fund managers who weight, or tilt, their portfolios in favour of their preferred shares are often better at stock…
