Concentrated Portfolios: Do they enhance performance?

I mentioned last week that concentrated portfolios tend to outperform widely diversified portfolios in the long-term. This 2013 article from Money Management offers support:

Fund managers who invest in concentrated portfolios are able to outperform those who invest in diversified portfolios by 400 basis points, according to research coming out of the United Kingdom.

Investment skills consultancy firm Inalytics examined nearly 600 equity portfolios in its database and found that portfolios with the lowest quartile of holdings performed over 400 basis points better than the highest quartile of holdings.

Inalytics chief executive Rick Di Mascio said there were a number of explanations for the research findings including manager skill set, survival bias and greater attention being given to smaller equity sets.

“One possible rationale is that only the most skilful managers are given the punchier portfolios to run. A good analogy is that only the very best racing drivers get to drive Formula 1 cars.”

“Another explanation is that the database may be biased towards successful managers who were given the opportunity and ‘survived’. Once again there is a parallel with the Formula 1 drivers, but at least in the case of fund managers it isn’t dangerous,” Di Mascio said.

“Third, from a behavioural finance perspective, the literature suggests that the lower the number of holdings in the portfolio, the more attention each one receives.”

“Whatever the explanation, the data is clear — the more concentrated the portfolio, the more likely the performance is going to be good,” he says.

Our own research with momentum portfolios overwhelmingly indicates that greater concentration leads to improved performance. But this is no free lunch. With increased performance comes increased volatility. Which is why you need a long investment horizon when investing in concentrated portfolios.