Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 563

The problem with concentrated funds

A topic I have changed my mind on during my career is concentration in funds. I used to be strongly of the view that it was only worth taking active investment positions if they came with high conviction – usually in the form of concentrated positioning – otherwise, what’s the point? Although I came to realise I was wrong about this, I am aware that many people far smarter than me remain advocates of this type of approach. Why do I think it is a problem when they don’t?

What is concentration in a fund?

Fund concentration is not the easiest concept to define. There are obvious examples such as very focused equity portfolios with large weightings in individual companies, but there is more to it than that. Concentration doesn’t have to be about position sizes in stocks, it can come through an extreme sensitivity to a certain theme, concept, or risk factor. It is about our exposure to specific and singular points of failure. Could one thing go wrong and lead to disaster?

The key concept to consider when thinking about the risk of concentrated funds is ergodicity. This is a horribly impenetrable term, but at its core is the idea that there can be a difference between the average result produced by a group of people carrying out an activity, and the average result of an individual doing the same thing through time.

Let’s use some simple examples.

Rolling a dice 20 times is an example of an ergodic system. It doesn’t matter if 20 people roll the dice once each, or an individual rolls the dice 20 times. The expected average result of both approaches is identical.

Conversely, home insurance is a non-ergodic system. At a group level the expected average value for buyers of home insurance is negative (insurance companies should make money from writing policies). So, why do we bother purchasing it? Because, if we do not, we expose ourselves to the potential for catastrophic losses. The experience of certain individuals through time will be dramatically different to the small loss expected at the average group level.

Investing is non-ergodic. Our focus should therefore be on our individual experience across time (not the average of a group); this means being aware of how wide the potential range of outcomes are and the risk of ruin.

In concentrated funds, the prospect of suffering irrecoverable losses at some point in the future is too often unnecessarily high.

‘Risk is not knowing what you are invested in’

One of the most common arguments made by advocates of running very concentrated equity portfolios is that it is an inherently lower risk pursuit because we can know far more about a narrow list of companies than a long list. If we have a 10 stock portfolio, we can grasp the companies in a level of detail that is just not possible if we hold 100 stocks, and this depth of understanding means that our risk is reduced. The first part of this is right, the second part is wrong.

The problem, I think, stems from the fact that there are two types of uncertainty – epistemic and aleatoric. Epistemic uncertainty is the type that can be reduced by the acquisition of more data and knowledge. Here the idea of portfolio concentration lowering risk makes sense. Conversely, aleatoric uncertainty is inherent in the system; it is the randomness and unpredictability that cannot be reduced. It doesn’t matter how well we know a company or an investment, we are inescapably exposed to this. The more concentrated we are, the more vulnerable we are to unforeseeable events.

While I think a neglect of aleatoric uncertainty is at the heart of unnecessarily concentrated portfolios, there are other issues at play. Overconfidence is likely to be a key feature. we may be aware that the range of outcomes from a concentrated approach is wide, but that may be desirous to us because we believe that our skill skews the results towards the positive side of the ledger. Given our ability to fool ourselves and the aforementioned chaotic nature of the system, this seems to be a dangerous assumption to make.

Unfortunately, there is also an incentive alignment problem. A wide range of potential outcomes from an investment strategy becomes very appealing if we benefit from the upside but someone else bears the downside. This asymmetry is inevitably one of the reasons why high-profile macro hedge funds so often seem to be swinging for the fence with concentrated views. The often-severe downside of the negative outcomes is borne primarily by the client (a situation no doubt exacerbated when a hedge fund manager is already exceptionally wealthy).

Running a very concentrated investment strategy places an incredibly heavy onus on being right and also leaves us acutely vulnerable to unforeseen events unfolding that can have profoundly negative consequences. Exposing ourselves to such risks willfully seems imprudent and unnecessary.

Investors are likely to overestimate how much they know, and underestimate how much they cannot know.

Being wary of concentration does not mean increasing levels of diversification are always beneficial. There is a balance to strike.

It feels important to note that the risk of concentrated strategies can be diversified by combining them, but we should still consider what the concentration levels say about the investor who is willing to adopt such an approach.

 

Joe Wiggins is Director of Research at UK wealth manager, SJP and publisher of investment insights through a behavioural science lens at www.behaviouralinvestment.com. His book The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions.

This article was originally published on Joe’s website, Behavioural Investment, and is reproduced with permission.

 

6 Comments
Barry
June 10, 2024

This is pretty much the shares vs property argument. Property is an ergodic investment. It doesn't matter who you are or what property you buy, you will pretty much get the average rental yield (if the tenant doesn't pay the rent then your landlord insurance will pay the rent for you so your income is pretty much guaranteed) and you will get your average capital growth based on inflation. There is not a wide range of outcomes possible. Shares are a non-ergodic system. The range of outcomes is extreme compared to real estate. Shares can go to 0 or they can 10-bag in a few months. Shares have an agency problem because you don't control what happens inside the company. The management does that, and they could have an incentive to look after themselves to the detriment of shareholders. If you want a slow and steady future that is pretty much guaranteed you go for property and if you want to have a shot at a 10-bagger with the risk of losing the lot, you go for shares.

Kevin
June 10, 2024

Well,nothing ever changes.The too much diversification is never enough brigade,and the concentrated portfolio one or two people ,and everybody that ever became the richest person in the world for a period of time. Reading the weekend update CBA hit a record high of $125.Using the 8th wonder if the world ( compounding) and rule of 72 then CBA from 1991 has gone well.Doubling the shareholding over a period of time then every 1 share is now ~ 7 shares. Slightly less than I thought .The share price is around double what I thought it would be. Way back when was exactly the same as today,if people can think of a company that went bust,that proves CBA will go bust Nothing could be more nailed on. People with a computer and an equation were brilliant at predicting the future,and getting everything precisely wrong to as many decimal places as they want to work to .Beware of geeks bearing formulas. 7 CBA shares ~ $125 each so $875 from a start of ~ $6 ( the $5 40 float was scaled back). Dividend has grown from 40 cents a share net ( company tax rate 39% if I remember correctly). Net dividend now 7 X $4.50 = $31.50. Gross that up and $45 ,unless my mental arithmetic is wrong The geeks bearing formulas will probably arrive shortly. The 100% guarantee is nobody can predict the future,all down to probabilities,just a matter of how close will the probability calculations be to reality,for that one day.Then it all changes again the next day. An average return minus costs over a long period will be satisfactory,if you put a lump sum in at the start.Having a go for yourself is great fun,but can be terrifying when the crash comes. NAB turned out pretty close to probability calculations over that period,perhaps ~ 10% either way on price,and the same for the shareholding using the DRP year after year until retirement and living off dividends Apparently set and forget is something else that should never be done

Dudley
June 10, 2024

"rule of 72":
More precise and general calculation of Doubling Time:
= log(2) / log(1 + Return%)

"compounding":
= Principal * (1 + Return%) ^ Time

Oodles of online calculators that will allow log() and ^ 'raising to power'. No need to limit to simple arithmetic.

Ronald
June 09, 2024

An employee from SJP commenting on "incentive alignment problems"? Hmmmm....

Steve
June 06, 2024

Hmm, so much to digest here. First up I think the idea that you can know more about 10 companies than 100 is complicated by the fact you need to know something about the other 90 companies to reject them from your shortlist. So at some point you need to look at a larger number of companies. Therein comes the criteria - are you thematic (eg AI is the next big thing), fundamental (ROI, leverage etc) or more inclined to look at quality of management (how the heck do you truly do that?). And it all comes down to risk - how many concentrated funds fail to deliver? Most of them. No advisor would ever suggest you put all your assets into one fund that has just 10 or 20 stocks, it is way too risky. So you spread your investment over say 5 or 6 managers, and all the potential benefits of concentration are gone (historically more of them will likely underperform the market!). Perhaps a lower risk option is instead of trying to find the great companies you try to eliminate the rubbish ones? A large proportion of stocks don't make any profit at all - they're out. Many have negligible or declining sales/revenue growth. They're gone. Some have way too much debt - they're gone. Some have a poor history of capital allocation - they're gone. The list shrinks quickly. Thankfully some ETF's do the screening for you (eg QUAL) but I think the lure of finding "the manager" who will kill the cow is just too much of an urban myth to spend much time thinking about. Even the infamous Berkshire is relying on its earliest growth to make its history look good - the last decade or so has been pedestrian.

Steve
June 06, 2024

Of course the key US Index, jammed-packed with NVIDIA & the Magnificent 7 stocks isn't concentrated either....lol

 

Leave a Comment:


RELATED ARTICLES

Diversification works?

The risks of market concentration and not staying invested

Are demographics destiny for the stock market?

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Shares

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

Exchange traded products

AFIC on its record discount, passive investing and pricey stocks

A triple headwind has seen Australia's biggest LIC swing to a 10% discount and scuppered its relative performance. Management was bullish in an interview with Firstlinks, but is the discount ever likely to close?

Superannuation

Hidden fees are a super problem

Most Australians don’t realise they are being charged up to six different types of fees on their superannuation. These fees can be opaque and hard to compare across different funds and investment options.

Shares

ASX large cap outlook for 2025

Economic growth in Australia looks to have bottomed, which means it makes sense to selectively add to cyclical exposures on the ASX in addition to key thematics like decarbonisation and technological change.

Property

Taking advantage of the property cycle

Understanding the property cycle can be a useful tool to make informed decisions and stay focused on long-term goals. This looks at where we are in the commercial property cycle and the potential opportunities for investors.

Investment strategies

Is this bedrock of financial theory a mirage?

The concept of an 'equity risk premium' has driven asset allocation decisions for decades. A revamped study suggests it was a relatively short-lived phenomenon rather than the mainstay many thought.

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.