Imagine you are a primary school headteacher. You are looking for a new job and there are two alternatives. The first involves a small school – there are a mere 20 pupils. It isn’t an easy job. You will be responsible for keeping a very close eye on the children, analysing their every move every day and hoping they reach their potential.
You also have to endlessly liaise with the school governors and with parents about each child. To add to your trying admin burden, you also have to keep a long waiting list of the children who you will take on when the ones you have move on.
The second job comes with the same responsibilities, boring admin tasks and reporting duties. The difference is that it houses 60 children – you have triple the number of needy kids to keep an eye on at any time and triple the number on your waiting (or watch) list.
The pay is the same for both and both offer the same level of general social and professional status, as well as the same opportunities for advancement.
Which would you choose – the one which makes you responsible for a small number of carefully chosen clever children, or the one where you take charge of an unruly rabble of some clever and some not so clever kids?
I wouldn’t need to think about this for long. I’d take the first – fewer children would allow me more time to get to know each child better and, hopefully, also give me more free time of my own.
However, I am not a fund manager. Look at the way most of them do their jobs and it seems likely that most would choose the second.
There is a huge amount of academic and practical research available into the optimum number of stocks that should be held in a portfolio (from Harry Markowitz’s Modern Portfolio Theory down). The results are pretty consistent.
They tell us that you must diversify a portfolio. If you only hold a couple of stocks, you run the risk of losing a large percentage of your money if one goes horribly wrong.
However, they also tell us that there is no point in diversifying too much: all the benefits of diversification in terms of cutting your risks can be gained by holding 15-20 stocks and there is almost no more benefit to be had from holding more than 25.
Holding more than 25 is, therefore, nothing more than a make-work scheme for junior fund managers and analysts.
Yet, despite this volume of research and the fact that (unusually) almost everyone agrees with its premise, the average fund manager holds more like 40-50 stocks in his portfolio and some hold 100 plus. That means huge trading expenses (the average fund manager turns over about 80% of his portfolio every year and the more stocks he has, the more he is likely to trade) and in research expense (all those company visits for starters).
It also means hours of extra work: instead of having 20 stocks to analyse and another 20-odd on their watch list they have hundreds to keep an eye on.
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So why do they do it? We need make-work schemes for clever young people in the UK at the moment. But given that it’s hard to accuse very many fund management firms of intense focus on altruism and social usefulness, I don’t think that’s what is going on here.
I am amused by the idea that our fund managers might all be great believers in the ‘homeopathic approach’ to investment (the more you dilute a portfolio, the better it works), but I don’t think that’s it either.
Instead, it is a mixture of things. Some are technical. Managers worry about liquidity. If they have large positions in a stock, will they be able to liquidate it should investors redeem in volume? And funds are subject to rules about how much of the portfolio any one stock makes up.
These can be valid problems – particularly at the small-cap end of the market. But I suspect the biggest factors in here are more psychological rather than technical.
There’s the fact that everyone hates to sell stocks that have gone up and replace them with new ones (what if the old ones go up further?). There is novelty. If you have new money coming into your fund, it is more fun to buy new holdings than top up old.
There is “be busy” syndrome – it’s hard to sit at a desk all day doing almost nothing and feeling you justify your rather too high salary when everyone else is buying new stuff.
There is the herding (whereby managers are more comfortable owning the stocks other managers own too) and there is, of course, career risk. I’ve written about this before, but there is more benefit to a manager in tracking their index (almost inevitable if you hold 100 stocks) than in underperforming it, even in the short term.
Finally, there is the fact that holding a smaller number of stocks with conviction requires a certain amount of mental stamina (idleness isn’t easy). Fund investors may think that stamina is what they pay for, but I’m told it’s just too hard.
So, what do you do? You can approach this in a simple way and just reject all funds with more than 25 holdings as being run by mentally weak lemmings, an approach that would probably end with you buying the excellent Fundsmith fund.
But you could also accept funds with 30-40 holdings on the basis that, in a good fund, only 25 or so of those will be core holdings – the rest will be positions in the process of being built up or sold down. This might take you to the Troy Income and Growth Fund.
Finally, you might make the odd exception for funds with 50-100 holdings. This sounds silly under the circumstances, but if you look at, say, the excellent Scottish Mortgage Investment Trust, you will see that it has 70 holdings.
However, the top 25-30 make up 80% of the portfolio, so in that sense, it almost fits the bill. The rest are companies in which a bigger position might be taken later or a spread in a newish sector in which it isn’t clear who will be the winner. It’s a bit like taking the first job above, but insisting on being allowed to run the nursery too.
• This article was first published in the Financial Times.