Over the years, the debate about the merits of both passive and active equity management has been raging. As the industry has grown, many investors have indexed their equity exposure. Unfortunately, the average money manager has been unable to beat the market.
One of the most common errors that investors make is over-diversification. Active investors can provide our clients with the necessary value to achieve their goals. One of the most important factors to consider when choosing an active manager is the portion of a portfolio that is different from its index.
Over the years, researchers have been searching for ways to improve the efficiency of financial markets to generate better returns. Unfortunately, most studies were unable to provide a comprehensive analysis of the various factors that can affect a fund’s performance. Recently, researchers have started to explain how a small number of funds can consistently outperform the market.
One of the most prominent studies in 2006 revealed a significant flaw in the US mutual fund industry. According to the study, over-diversification can lead to underperformance. For instance, funds with low active shares tend to perform poorly compared to their high active counterparts. These over-diversified funds are commonly referred to as closet index funds and are typically managed for the benefit of their parent company.
Although the empirical evidence supporting the use of active shares is limited, there are other reasons for investors to maintain a concentrated portfolio. For instance, behavioral finance theory suggests that high trading activity levels can lead to overconfidence. However, the literature on this subject shows this is not the case.
One of the most critical factors investors should consider when choosing an active manager is the ability to evaluate a company properly. In his 1996 letter, Warren Buffett noted that an investor does not have to be an expert to assess a company properly.
The characteristics of a concentrated manager are usually focused on staying within their circle of competence. This discipline allows them to maintain their significant positions.
One of the main reasons why investors should maintain a concentrated portfolio is the lack of suitable investments. A manager may only find a few opportunities each year to invest in, and they prefer to hold positions in companies that meet their criteria.
Contrary to popular belief, a diversified portfolio won’t protect your wealth or provide you with a smooth ride through the market. Managers who are focused on their best ideas can increase their chances of achieving attractive long-term returns. The deep knowledge of each position also helps minimize the risk of capital loss. This approach is supported by empirical evidence and is highly logical.