Concentration Beats Diversification, Study Finds

Concentration, rather than diversification, may be a driver of outperformance, according to a study.

Home country, foreign country, and industry concentration in institutional portfolios led to higher-than-average returns, according to a study by financial economists Mark Fedenia (University of Wisconsin-Madison), Tatyana Sokolyk (Brock University), and Nicole Choi and Hilla Skiba (University of Wyoming).

The study examined these three measures of portfolio concentration in the security holdings of nearly 11,000 institutional investors around the world.

“In contrast to the traditional asset pricing theory, concentrated investment strategies in international markets can be under-diversified but optimal,” the authors wrote.

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When investors overweigh certain markets and industries, the researchers found, they made a rational decision based on information advantage and economies of scale.

“Investors can earn excess returns from knowing information other investors do not know.”

The study showed that institutional investors benefited from specializing in a specific area and concentrating allocations to exploit this information advantage. According to the research, these investors achieved better overall performance than those with more diversified portfolios.

A report by Cambridge Associates last year had a similar conclusion, finding that the average concentrated manager outpaced the average unconcentrated manager by over 125 bps.

Advocate Health Care CIO Leslie Lenzo, who transformed her fund’s $6.5 billion portfolio into a basket of niche, concentrated funds, told CIO earlier this year that the value of concentration was often overlooked.

“With developed market international equities, for example, we don’t expect our managers to look anything like the benchmark,” Lenzo said. “You just start out at a much higher probability of alpha that way.”

Read the full report, "Portfolio Concentration and Performance of Institutional Investors Worldwide."

Randomly selected stocks underperform the overall market more often than they outperform, according to researchers, due to their theoretically unlimited upside and finite downside.

Furthermore, this likelihood of underperformance is even more costly to investors than the fees incurred from hiring an active manager, wrote attorney and scholar JB Heaton, statistician Nick Polson (University of Chicago), and quant Jan Hendrik Witte (University of Oxford)

“Our results suggest that that the much higher cost of active management may be the inherently high chance of underperformance that comes with attempts to select stocks,” they wrote in “Why Indexing Works,” published earlier this month. “To the extent that those allocating assets have assumed that the only cost of active indexing above indexing is the cost of the active manager in fees, it may be time to revisit that assumption.”

For the study, the authors constructed a simple model with five securities, in which active managers picked one or two stocks and weighted them equally. Four of the stocks returned 10% over the period, while one returned 50%—meaning only those managers skilled (or lucky) enough to select the winning security were able to beat the index.

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The result was that the risk of substantial index underperformance always dominated the chance of substantial index outperformance, with the difference being greater the fewer stocks a portfolio included relative to the index.

“It is far more likely that a randomly selected subset of the 500 stocks will underperform than overperform, because average index performance depends on the inclusion of the extreme winners that often are missed in sub-portfolios,” they wrote.

As the authors conclude, the “stakes for identifying the best active managers may be higher than previously thought.”