The 12 months to December 2006 was widely acclaimed as another great period for Australian equity investors with the share market returning 20-plus per cent for a third successive year. Yet for active managers the median alpha for the 12 months was the lowest in 19 years. In such a low relative return environment, largely as the result of low benchmark volatility, managers and investors are turning to highly concentrated equity offerings.
Some argue that on the basis of risk these products are not substantially different from their diversified peers. This view is based on analysis that shows portfolios gain little diversification benefit beyond 25-30 stocks (from the same universe, as risk is measured relative to the benchmark from which they are drawn). Risk that is able to be diversified away has at this point been largely diversified away.
However, while aggregate portfolio level volatility relative to the benchmark does not decline rapidly after 25-30 stocks, this is not the same as saying that concentrated portfolios have the same risk factors as diversified portfolios. Let’s examine three ways in which these portfolios possess different risk characteristics compared to more traditional (diversified) funds.
Concentrated equity portfolios are typically “overweight growth and small stocks, whereas managers of more diversified funds hold portfolios that closely resemble the total market”, according to a recent article, “On the Industry Concentration of Actively Managed Equity Mutual Funds”, in The Journal of Finance. This may mean when value-style factors dominate that these portfolios substantially underperform, such as in the year to March 2001 when value (Macquarie Value ASX 300) outperformed growth (Macquarie Growth ASX 300) by 27 per cent.
Secondly, given their style biases, concentrated portfolios typically have a low level of sector diversification. This exposes concentrated portfolios to a high degree of systematic risk. Yet sector risk, as measure by the variance in sector performance, is pronounced.
Sector risk is amplified by its unpredictability. Sector allocation is difficult as it is hard to identify systematic pricing abnormalities. Sector underweights that are an outworking of stock selection may have significant unintended consequences. For example, during the technology boom in the United States in 1999 the telecommunications, media and technology (TMT) sectors in aggregate were up more than 120 per cent yet utilities declined 10 per cent. The next year the reverse was the case with utilities up 20 per cent, while TMT sectors declined 40 per cent.
The variance between sectors, and their contribution to aggregate portfolio return has become important and more pronounced over the past decade, according to a recent Geneva Research paper, “Country, Sector or Style: What matters most when constructing Global Equity Portfolios?: An empirical investigation from 1990-2001”. Global equities manager Putnam recently noted sector allocation had become more important than country allocation in determining return for global equity portfolios. Sector allocation is so difficult that many international equity managers, such as Wellington and (in some products) BGI do not bother, citing too many unsystematic drivers of return. These managers have portfolios that are industry group neutral and focus on generating alpha from individual stocks within these sectors.
Thirdly, risk-return payoff as measured by information ratio may be lower for concentrated equity portfolios. Lets take a hypothetical example: if there are two managers of comparable skill yet one is concentrated (30 stocks) and the other more diversified (60 stocks), which should the investor choose? Investors concerned about maximising their information ratio should always choose the second manager as this manager has greater opportunity (breadth) for his skill to be leveraged.
The concentrated portfolio may outperform in certain periods yet the diversified portfolio (assuming comparable skill) will always deliver better riskadjusted returns.
In conclusion, the style and size bias of concentrated portfolios, combined with sector tilts, means performance is likely to diverge significantly at times (both on the upside and downside) from the benchmark. If the skill level of all active managers was equal we would expect concentrated equity managers to have lower risk-adjusted returns (as measured by the information ratio) than diversified managers. Yet all things are not equal.
This brings us back to our start. What are investors to do in an environment where low volatility hampers the ability for active managers to add return? Concentration is surely an appealing alternative that offers the promise of higher returns (that some have achieved in the last year). Yet investors should weigh the potential of higher returns against the higher risks needed to achieve such returns.
