Focused on Seeking Outperformance

Increased attention is being paid to the inclusion of focused mutual funds in portfolio allocations. Studies have shown that concentrated portfolios can provide meaningful performance advantages over time.

January 2019

  • David Rainey
    David Rainey, CFA
    Co-Portfolio Manager
  • Brian Macauley
    Brian Macauley, CFA
    Co-Portfolio Manager
  • Ira Rothberg
    Ira Rothberg, CFA
    Co-Portfolio Manager

Mutual funds that hold a relatively large number of positions are often thought to have less risk than funds that hold fewer positions. However, studies have shown that concentrated portfolios, generally those with fewer than 25 portfolio holdings, do not have a higher risk profile and can provide meaningful performance advantages over time.

A review of academic studies shows the following:

High Conviction Investment Ideas Have Outperformed

The investment ideas in which active mutual fund managers had the greatest conviction consistently outperformed the rest of the positions in their portfolios and the market, between 1984 and 2007, by about 1 to 2.5 percent per quarter, depending on the benchmark.1

Highly Concentrated Funds Have Outperformed

Mutual fund managers willing to make “big bets” by concentrating their portfolios’ assets have outperformed managers of more highly-diversified portfolios. In a study known as, ‘Big Bets,’ it was found that domestic stock portfolios with large weightings in a relatively small number of holdings delivered higher returns—both before and after expenses—than portfolios which held more uniformly weighted positions. These focused, “big bets” portfolios delivered approximately 30 basis points of additional performance each month, or roughly 4 percentage points of additional return each year.2

Focused Funds Have Not Exhibited Higher Risk

Some investors may believe that concentrated mutual funds expose investors to greater risk than more highly-diversified options. While systematic risk cannot be eliminated, research has shown that holding 20 stocks can significantly reduce unsystematic risk (see Chart 1).3

 

1 Randolph B. Cohen, Christopher Polk, and Bernhard Silli, “Best Ideas”, MIT, LSE, Goldman Sachs, April 20, 2010.

2 Klass Baks, Jeffrey Busse, and Clifton Green, Fund Managers Who Take Big Bets: Skilled or Overconfident, American Finance Association 2007 Meetings Paper. “Best Ideas”, a study conducted by Bernard Cohen of Massachusetts Institute of Technology, Christopher Polk of the London School of Economics, and Bernard Silli of Goldman Sachs, found that between 1984 and 2007, mutual fund managers’ “best ideas”—the ideas in which they had the greatest conviction—outperformed the market by about 1 to 2.5 percent per quarter, depending upon the benchmark. The study found that “best ideas” generated: “…Statistically and economically significant risk-adjusted returns over time but they also systematically outperform the rest of the positions in managers’ portfolios… this result is consistent across many specifications: different benchmarks, different risk models, and different definitions of “best ideas”.

3 John Campbell, Martin Lettau, Burton Malkiel, and Yexiao Xu, Have Individual Stocks Become More Volatile, The Journal of Finance, Vol. LVI, No. 1, February 2001.