Here’s the ultimate test for investment managers: can they beat inflation by an annualised 4.5 percentage points for the next 10 years? This is a useful exercise and one that leads to the ultimate question: what is the highest-probability path for achieving an ambitious investment goal?
One approach is The Vanguard Way: allocate to higher-risk, higher-return asset classes; index within each asset class; trade only on occasion; and keep expenses near zero. That strategy requires the stock market’s blessing; if global equities don’t outpace inflation by several percentage points, the portfolio will almost certainly lose. Should stocks perform well, however, the manager will succeed in the task.
Another approach is to obtain the desired extra return by hiring superior investment managers. That tactic is currently out of favour, particularly with retail fund shareholders. But it may come back in style.
One way is to buy concentrated funds, probably very concentrated. In institutional investment speak, this means hiring managers who have “high tracking error”. Most of the stock funds that have high tracking error – meaning they deviate sharply from the returns of an index – are funds that hold relatively few securities, with relatively high weightings for their top positions.
Managers Make Bold Bets to Outperform
Assume that over the decade, the stock market will beat inflation by a modest 1.5 annual percentage points. Thus, a fully indexed stock portfolio would lag the goal by 3 percentage points – so the portfolio needs an “alpha” of 3%.
If you must have 3% alpha, then aim higher. After all, an investment manager who targets 3% alpha will hit that mark half the time, and fall short half the time. Often, that 50% shortfall rate will be acceptable in the grand scheme of things. But under the strict rules of our test, the manager has failed.
Targeting a high alpha means deviating substantially from a benchmark index, which in turn means holding a concentrated portfolio. The investor who seeks the best chance of reaching an ambitious target, and who has access to investment managers who possess genuine skill, should look for portfolio managers who concentrate their holdings and make bold bets.
Those managers should be plural, not singular. Assuming that the results attributable to manager skill are independent, so that one manager’s fortunes aren’t related to another’s, then the basic principles of diversification apply. Allocate the portfolio to several concentrated funds, rather than place all eggs into a single basket.
Retail Investors Shun Concentrated Funds
The lesson for retail investors is less inspiring. The institutional marketplace, which includes hedge funds, private equity funds and venture capital funds, offers concentrated investment funds that can indeed be expected to outperform the overall stock market. Not always, of course, and certainly not in all years. But enough to assist the savvy institutional investor. For various reasons, that is not so with retail funds. In general, concentrated stock funds do not outperform standard funds.
The case for retail investors using concentrated funds, then, applies in theory but not in practice. This time, the fault is not the fund investors'. Fund investors would probably misuse concentrated funds by performance-chasing, as so many institutional buyers do. However, investors do no such things, because they, quite correctly, avoid concentrated funds. Those funds haven't performed well enough to deserve the assets from retail investors.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
