By LARRY SWEDROE
In theory, a manager with skill has more dollars allocated to their best ideas — the returns of portfolios consisting of only a manager’s best ideas will be undiluted by less-promising ideas. Thus, investors should seek out skilful managers who build concentrated portfolios. While there is no doubt that active management underperforms in aggregate and the majority of active funds underperform every year (the percentage that underperform increases with the time horizon studied), if an investor were able to identify the few future winners by using concentration as a measure of skill, active management could be the winning strategy.
Concentration is related to active share, a measure of how much a fund’s holdings deviate from its benchmark index. There is a large body of evidence demonstrating that it is difficult to make the case that active share has any predictive value in terms of future risk-adjusted outperformance of actively managed mutual funds. For example, in their November 2021 study Is Active Share Unattractive?, Morningstar found that despite exhibiting greater risk, high active share funds failed to deliver superior net-of-fee results in any category. Providing further evidence, Martijn Cremers, Jon Fulkerson and Timothy Riley, authors of the study Active Share and the Predictability of the Performance of Separate Accounts, published in the First Quarter 2022 issue of the Financial Analysts Journal, found that while an unconditional sort on active share among separate accounts was insufficient to identify future outperformance, conditional on the level of active share, past performance can identify separate accounts that continue to outperform: among separate accounts within the top 20 percent of active share, a portfolio of those within the top 20 percent of past performance had a statistically significant (at the 5 percent confidence level) net alpha of 1.38 percent per year (t-stat = 2.11). However, in a test of robustness, the same double sorting on mutual funds did not produce findings of statistical significance. (Note that for large institutional investors, separately managed accounts typically have lower fees than mutual funds and fewer cash flows, resulting in lower trading and market impact costs, helping to explain the difference in performance.)
Cremers, Fulkerson and Riley also found that for a portfolio of separate accounts with strong past performance among those with high active share, there was more future outperformance inside the small-cap style. However, in the large-cap style there was no evidence of persistent outperformance. And the results were even weaker among mutual funds.
Chris Tidmore, author of the study Fund Concentration: A Magnifier of Manager Skill published in the July 2022 issue of The Journal of Portfolio Management, examined the impact of decisions to increase concentration on performance. Using holdings and industry-based concentration data from active equity funds, he tested how concentration impacted the dispersion of relative returns and whether there was a difference in how concentration impacted funds that outperformed versus those that underperformed. Tidmore focused on two categories of manager-driven concentration measures — security level, or holdings-based, and industry-based — as well as the number of holdings and percentage of assets in the top ten holdings (common individual security-level concentration measures in the practitioner literature). His database was from Morningstar Direct and covered U.S. domestic equity-focused mutual funds over the 21-year period ending December 31, 2020. Following is a summary of his findings:
- As concentration increased, the dispersion of performance generally increased.
- In aggregate, alpha had near-zero correlation with concentration.
- It is important to account for not only holdings-based measures of concentration but also industry-based measures when looking to understand the effect of concentration on dispersion of relative performance. Thus, for investors and gatekeepers who focus on holdings-based measures of concentration, the findings show that you can’t just look at holdings-based measures of concentration without considering industry exposures.
- While increasing concentration had a positive impact on performance for outperforming funds, the opposite was true for underperforming funds.
- Higher levels of concentration generally hurt the poorly performing funds more than it helped the outperforming funds.
His findings led Tidmore to conclude that increasing concentration has a pronounced positive impact on performance at the top and an even more pronounced negative impact on the bottom tails of performance distributions, with industry concentration playing a significant part in understanding the relationship between holdings-based measures of concentration and dispersion of excess returns. Unfortunately, Cremers, Fulkerson and Riley found no evidence that their measure, active share, even when combined with past performance, provided any statistically significant evidence that allowed investors to identify in advance mutual funds that would outperform. And the evidence was particularly weak in large-cap stocks, which dominate market capitalisation and thus most investor portfolios.
For the typical investor who invests in mutual funds, the weight of the evidence suggests that neither active share nor concentration provides much, if any, valuable information in terms of future performance.
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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