The Third Pig

Those of you who have read our Client Letters and are familiar with our services know that we are proponents of concentrated portfolios. Of course this belief runs contrary to most of the discourse that exists in the investing public today. Most investors and investment professionals are devout followers of modern-portfolio-theory (MPT) and the efficient-market-hypothesis (EMH). MPT holds that the more diversified a portfolio, the less risk (in terms of volatility) from each of its individual positions. EMH states that stock market prices reflect the collective knowledge and judgment of all investors and thereby reflects the correct price. In other words, no individual investor can gain an advantage over the stock market by selecting specific stocks.

We think that both MPT and EMH are (mostly) bunk. We indeed think that it is possible to beat the market and at less volatility risk by choosing just a few stocks. Two recent articles support our view. A New York Times article about the record of concentrated portfolios points out that:

"...concentrated funds come out slightly ahead (of diversified funds). They returned 8.9 percent a year, on average, over the last 10 years, versus 8.7 percent for the diversified funds, according to Morningstar."

"A low-risk concentrated portfolio may sound like a contradiction in terms. After all, the belief in diversification as a way to reduce risk is sacrosanct, and the average domestic equity fund holds 175 stocks. But academic studies show that as few as 50 stocks can give a portfolio volatility levels equal to those of the Standard & Poor's 500-stock index. And many funds get by with less. A screen of those with fewer than 50 stocks on fund tracker Morningstar's database found that more than half had lower betas -- a measure of risk -- than the S&P 500. One-third had lower standard deviations -- which Morningstar measures as the month-to-month variation in the price of fund shares. What's more, according to a 2004 Morningstar study, some 80% of concentrated funds -- also known as focused funds -- outperformed their peers from 1993 through 2003."

An advantage of running concentrated portfolios not addressed in either article is the tendency for such funds to have much lower than average turnover ratios. The turnover ratio is the percentage of a fund's assets that have changed over the course of a given time period, usually a year. The turnover ratio for a mutual fund is calculated by dividing the average assets during the period by the lesser of the value of purchases and the value of sales during the same period.

Portfolios with high turnover ratios (i.e. high levels of buying and selling) tend to have a higher degree of taxable events. Managers that run concentrated portfolios usually create fewer of these events as they tend to buy and sell much less often. Concentrated funds also tend to have much lower trading costs than the average fund. A perusal of the Morningstar database shows that mutual funds with 40 or fewer stocks have an average turnover ratio of 40.7% while the average mutual fund is closer to 100%.

In other words, even if concentrated funds didn't outperform more diversified funds on an outright basis, once costs are considered concentrated funds would come out ahead anyway. Bottom line we tend to agree with the conclusion of a study on concentrated funds presented in The Journal of Finance:

"We find that funds with concentrated portfolios perform better than funds with diversified portfolios."