Fill your portfolio with your very best ideas

Fund managers’ top picks beat the market, but the rest of their portfolios often add little value, says Chris Sholto Heaton.

The top dogs convincingly beat the rest

It’s widely accepted that your portfolio should be well-diversified to prevent a single disastrous decision from wiping out a large chunk of your wealth. At the same time, if a portfolio is too large, your chances of outperforming the market shrink and you might as well hold a cheap tracker fund.

These extremes are self-evident: the big question is the number of holdings that gives you the best trade-off between return and risk. Research by Miguel Antón of the University of Madrid, Randolph Cohen of Harvard Business School, and Christopher Polk of the London School of Economics gives us an interesting way to think about this. Their paper Best Ideas looks at how many of a fund manager’s highest-conviction stocks make a contribution to beating the market.

Based on holdings in US mutual funds between 1983 and 2018, they found that managers’ top picks outperformed the market by 2.8%-4.5% per year on average (depending on exactly how you measure risk-adjusted performance) – but this only extends to the top three-to-five highest-conviction ones. “The vast majority of the other stocks managers hold do not exhibit significant outperformance.”

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Drag on returns

If investors only have a few stellar ideas at any one time, this implies that portfolios pretty rapidly grow to the point where no potential alpha gets added. Given that many funds run portfolios of 50 or even 100 stocks, it’s obvious that the vast majority can’t contribute much and the extra cost and time of looking after them is a drag on returns. However, cutting the portfolio down too much means that risk soars.

With five stocks, the cost associated with one going badly wrong is vast – and even if all ideas ultimately work out, volatility along the way will usually be staggering. For institutions, one answer could be to divide a portfolio up by regions and industries, and hire different managers to run ultra-concentrated fivestock portfolios in each area, suggests Cohen in an interview with Citywire. The result would be a diversified portfolio, but one that does not simply replicate the market.

Private investors can’t do the same and in any case our portfolios are often quite concentrated. Still, this kind of thinking may help.

Does your portfolio consist of your very best ideas across several complementary sectors and strategies, or alternatively a smaller number of high-potential picks plus a cheap tracker to diversify away some of the risk? Or have you ended up with a large pool of similar stocks, all driven by the same factors? Do you hold a few distinctive focused funds? Or have you got a grab-bag of 100-stock monsters that just add up to the market portfolio?

In short, assume that you may only make a few good decisions, then try to do so in a way that gives the successes a chance to make a difference.

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Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.