Indexology^® Blog

Should active managers shift away from well-diversified portfolios and concentrate only on “high conviction” holdings in hope of generating higher returns?  We have suggested four consequences — higher risk, greater dominance of luck over skill, higher costs, and fewer outperforming funds — that are likely and logical outcomes of higher concentration.  All four apply even for active managers with genuine stock selection skill.  Once we consider the nature of skill, however, the case against greater concentration becomes even more compelling.

The argument for concentration relies on two assumptions: that manager skill exists, and that it is particularly acute at the extremes of conviction.  Not only, e.g., must a manager be able to build a 100-stock portfolio that will outperform, he also must be able to identify which 20 stocks of the initial 100 are the best of the best.  For concentration to work, both assumptions — that skill exists, and that it is acute at the extremes — must be true simultaneously.  There is no evidence that either of them is.  If it exists at all, the requisite skill must be quite rare.  If this were not so, active funds would not be facing a performance challenge in the first place.

On the contrary, the evidence that manager skill is ephemeral is strong:

• The only source of excess return, or positive alpha, for the market’s winners is the negative alpha of the losers.  In aggregate, professional active management is a zero-sum game.
• Because passive investors own a pro-rata slice of the market, their aggregate portfolio is identical to the aggregate portfolio of all active managers. But passive investment is intrinsically cheaper than active management, so that the average passively-managed dollar is arithmetically certain to outperform the average actively-managed dollar.
• In support of these conceptual points, the empirical evidence is unequivocal.  Most active managers underperform benchmarks appropriate to their investment style, and the comparisons become more arduous as the timeframe for evaluation lengthens.  Moreover, when above-average performance occurs, there is scant evidence that it persists.

Skillful managers sometimes underperform; unskilled managers sometimes outperform.  The challenge for an asset owner is to distinguish genuine skill from good luck.  The challenge for a manager with genuine skill is to demonstrate that skill to his clients.  The challenge for a manager without genuine skill is to obscure his inadequacy.  Concentrated portfolios will make the first two tasks harder and the third easier.

This morning’s S&P CoreLogic Case-Shiller Home Price Indices report showed prices rising at about a 5% annual rate over the last 12 months.  Across the country the pattern varies with strong price gains in the Pacific Northwest and small price increases in New York and Washington DC.  The press release and data are available at LINK.

One factor in rising home prices is rising incomes as seen from the chart of the S&P CoreLogic Case-Shiller National Index and Disposable Personal Income per capita. Currently home prices appear to be running ahead of income.

The table shows the peaks and troughs, index levels and changes for the 20 cities and composite indices.

Part of the price increases in home is inflation. This chart shows the National Index and compares it to the inflation-adjusted version of the National Index. The inflation adjustment is based on the Consumer Price Index,

Can active managers improve performance by moving from relatively diversified to relatively concentrated portfolios?  Doing so is likely to increase risk, shift the relative importance of luck and skill, and raise trading costs.  A fourth consequence is that the probability of active underperformance is likely to increase.

A simple example provides some insight.  Imagine a market with five (equally weighted) stocks, whose performance in a given year is shown below.  The market’s return is 18%, driven by the outstanding performance of stock E.We can form portfolios of various sizes from these five stocks.  There are five possible one-stock portfolios, four of which underperform the market as a whole.  Alternatively, there are also five possible four-stock portfolios, four of which outperform the market as a whole.  The expected return of the complete set of one-stock and four-stock portfolios is the same 18%, but the distribution of portfolio returns is different.  In this case, holding more stocks increases the likelihood of outperformance.

Of course, this stylized example only “worked” because our hypothetical returns were skewed to the right; formally, the average return was greater than the median return.  A different return pattern among the individual stocks would have produced a different result at the portfolio level — so the usefulness of our example hinges on an empirical question: to what degree are real-life stock returns skewed to the right?

We might suspect that there is a natural tendency toward a right skew in equities — after all, a stock can only go down by 100%, while it can appreciate by more than that.   We confirmed this intuition by plotting the distribution of cumulative returns for the constituent stocks of the S&P 500 for the 20 years ended May 2016.  The median return was 141%, far less than the average of 377%.

This positive skew in equity returns is not simply a long-term phenomenon: in the 25 years between 1991 and 2015, the average S&P 500 stock outperformed the median 21 times.

If stock returns are skewed to the right, portfolios with fewer stocks are more likely to underperform than portfolios with more stocks, because larger portfolios are more likely to include some of the relatively small number of stocks that elevate the average return.  Indeed, the logic of skewed returns is that it is more sensible to focus on excluding the least desirable stocks than on picking the most desirable — the opposite of what a concentrated portfolio will do.

The municipal bond market tracked by the S&P Municipal Bond Index has seen a 4.11% year-to-date return.  Investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index have seen a 3.95% return.

What states are leading the pack?  The answer includes some of the states that have been performance drags in the past.  Municipal bonds issued within Puerto Rico, New Jersey and Illinois are in the top five at this point in 2016.  Puerto Rico revenue bonds have held on to their bounce off the bottom despite Puerto Rico’s default earlier this month.  As for bonds from other states, the demand for bonds with any incremental yield over other bonds has helped push up the prices of bonds issued within states such as New Jersey and Illinois.

Throwing anchor at the bottom of the pack are bonds issued from Virgin Islands which represent a relatively small segment of the municipal bond market but a lot of debt to carry for a small population. As a result, bonds from Virgin Islands are suffering in the shadow of Puerto Rico’s struggles. Municipal bonds from oil states such as New Mexico and North Dakota remain in positive return territory but are beginning to show the impact of the economic drag low priced oil has created.

Table 1) Top five state municipal bond indices sorted by year-to-date total returns:

Table 1) Bottom five state municipal bond indices sorted by year-to-date total returns:

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Some active managers argue that the remedy for widespread active underperformance is more aggressive, more concentrated portfolios.  If this is the correct prescription, it has a number of adverse side effects — for example, risk is likely to increase, and the relative importance of skill and luck in decision making is likely to shift in luck’s favor.

A third consequence is that trading costs are likely to increase significantly.  This is because — with more concentrated portfolios — both fund turnover and cost-per-trade should rise. Here’s a simplified example:  Two managers share the same security rankings but construct their portfolios differently.  The first manager selects the top-ranked 10% of the universe, and operates the more concentrated fund. The second manager excludes the bottom-ranked 10% of the universe (and therefore holds the top-ranked 90%).  Suppose that in each quarter there is X% turnover in the securities ranked in the top 10% and the same X% turnover among the worst 10%.

Consider the turnover required for each manager, assuming that their portfolios are equally weighted and that they both rebalance once per quarter:

• The concentrated manager holds the top 10% of the universe.  His turnover will therefore be X%.
• The diversified manager holds everything but the bottom 10%. There is X% turnover in the stocks he doesn’t own, which leads to a turnover of (X/9)% in those he does.

In this scenario, the concentrated manager’s turnover is nine times higher than the diversified manager’s turnover.  Of course, the specifics depend on what fraction of the universe each manager chooses to hold.  (With quintiles instead of deciles, the concentrated manager’s turnover would be “only” four times higher than the diversified manager’s.)  But it’s difficult to escape the conclusion that turnover will rise as concentration rises.

Moreover, transaction costs per trade are also likely to rise.  Transaction costs are not linear: it typically costs more to trade a higher percentage of the outstanding float in a security.  Otherwise said, a manager is likely to be able to purchase 10,000 shares in each of 100 companies with less market impact than he could buy 1,000,000 shares of a single company.

Thus, higher concentration can deliver a double blow to returns: higher turnover and a higher unit cost of execution.