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 it about these high conviction managers that makes them so effective - and how can we take advantage?
Not all fund managers are equal
We recently wrote 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 U.S. 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 picking and identifying the strengths and weaknesses of companies generally. By comparison, managers with a tendency to weight their positions in line with the market are less able to correctly spot which stocks are most likely to outperform.
Interestingly, this research tallies with earlier findings (Kacperczyk et al.) that fund managers who concentrate on specific sectors also outperform. Here it was found that those managers who ditched a broad based approach and focused on specific sectors based on informational advantages or expertise, outperformed their counterparts by around 1% annualised. Notably, this research also found that sector concentration led fund managers to tilt towards growth and small stocks in particular.
Profiting from big bet positions
While the active fund management industry has attracted criticism for charging high fees for funds that sometimes seem to simply track a benchmark, it's clear that there are lessons to learn from those with the confidence to deviate from the crowd. In a similar way that tracking a fund manager's best ideas can be highly predictive, identifying those with the conviction to place big bets and run concentrated portfolios offers an insight into the views of the most skilled stock pickers in the market.