Most active managers fail most of the time, at least if we regard their underperformance of passive benchmarks as indicative of failure. This fact is so well known and widely documented that even staunch advocates of active management acknowledge it.
What remains in dispute is what should be done to improve performance. Some argue that active management fails because it is not active enough. Active managers, it’s said, are reluctant to deviate too much from a passive benchmark, knowing that their performance will be compared to it. The proposed remedy for such “overdiversified” portfolios is for managers “to invest with high conviction, concentrating capital in the ideas they think are most likely to deliver strong long-term returns.”
Suppose that the active management community takes this advice, so that portfolios become substantially more concentrated in each manager’s “best ideas.” What might the result be? We’ve recently identified four logical consequences of increased portfolio concentration.
First, risk is likely to increase. Other things equal, more securities mean more diversification. Between 1991 and May 2016, the average volatility of returns for the S&P 500 was 15%, while the average volatility of the index’s components was 28%. The difference between one stock and 500 is an extreme case, but it serves to illustrate the obvious point: if the typical active manager owns 100 stocks now and converts to holding 20, the volatility of his portfolio will almost certainly increase.
In a world where all active managers concentrate their portfolios, fund owners who are not willing to accept an increase in active risk have two options. The first is for asset owners to retain the same number of active managers as before, but reduce the proportion that is actively managed. This is not in itself objectionable, although it may not be what the advocates of concentration intend, and it forces asset owners to reduce the proportion of their allocation that they hope will outperform.
Alternatively, asset owners must hire more active managers. Instead of using 20 managers each with 100 stocks, for example, a fund might achieve the same risk profile with 100 concentrated managers, each holding 20 stocks. As well as considerable additional time and expense for the asset owner, this produces a major logical inconsistency. In the name of conviction, managers who pick stocks are told to pick fewer stocks. As a consequence, asset owners who pick managers may be required to pick more managers.