Background

Many empirical studies have shown that a value style approach to share investing has consistently outperformed growth investing – and with less risk. Other studies have shown that lower volatility portfolios, particularly lower beta portfolios, outperform higher beta portfolios.  Concentrated equity portfolios have also proven to outperform their more diversified counterparts.

If value, lower beta and concentrated portfolios have consistently outperformed in the past, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago as they have been documented for many years. In fact, these so called ‘anomalies’ are a permanent feature of share markets.

The first two articles looked at the value investing and low beta portfolios anomaly. This article focuses on the third anomaly – the outperformance of concentrated portfolios.

Diversification or “diworsification”[1] : The case for concentrated portfolios

A third source of outperformance for equity portfolios is concentrated portfolios.  Studies have shown that concentrated portfolios are more likely to outperform their more diversified counterparts.

One such study, conducted in 2006 by Jeffrey A Busse, T Clifton Green and  Klass Baks at the Emory University concluded that “focused (ie concentrated) managers outperform their more broadly diversified counterparts by approximately 30 basis points per month, or roughly 4% annualised”.[2]

Another group of academics (Randolph B. Cohen, Christopher Polk and Bernhard Silli)[3] have found that institutional managers do have some identifiable skill in picking stocks. The researchers evaluated the performance of institutional investors ‘best ideas’, which they defined as being those stocks with the highest active positions.

Chart 1 sourced from Cohen, Polk and Silli’s Best Ideas paper, shows the alpha generated by managers’ best idea, second best idea, down to their tenth best idea. What is evident is that the manager’s largest active positions do in fact add significant value.

This is an interesting finding given the widespread belief, backed to some degree by academic research, that institutional active managers as a group do not add value, especially after fees. Given the research from Cohen, Polk and Silli indicates managers actually can identify stocks which will outperform, why then, as a group are they not capable of adding value to investors’ portfolios?

The question is seemingly answered by another interesting finding from the research. Diversification within individual portfolios increased materially over the past 30-odd years. Chart 2 shows the growth in the average number of companies held in US mutual funds doubled between 1984 and 2007.

Chart 2 suggests that while institutions are capable of finding good investments, they dilute the benefit through excessive diversification.

The obvious question that follows is why does this occur? Cohen, Polk and Silli offer a number of potential explanations:

1.     Regulatory/legal. Do legal standards such as the ‘prudent man’ lead to over-diversification in the name of regulatory risk aversion?

2.     Price impact, liquidity and asset gathering. Many institutional managers are paid as a percentage of funds under management. Consequently they have a financial incentive to maximise funds under management. With liquidity limitations and price impact increasing with the weight of money applied, institutions that exhaust the capacity of their alpha- generating ideas may be tempted to continue collecting funds under management and applying it to less attractive opportunities.

3.     Career risk. Underperforming managers face the risk of losing their jobs. Consequently, simply for self-preservation reasons, fund managers may choose not to deviate materially from the benchmark. It has been noted that it is only those managers that materially underperform their benchmarks that tend to be dismissed by clients. Mediocre managers tend to be retained.

Armed with this knowledge, what should advisers and institutional investors do?

There are a number of options that could be considered:

• Look for managers with performance fees. This will limit the incentive for asset gathering.
• Take a longer-term view of performance. This will empower your fund managers to take appropriate risks without the fear of being replaced should there be a period of short- term under performance.
• Accept that you need to do something different. For an outcome to be different to everyone else (ie the market), you need to do something different.
• Look for unconstrained portfolios or benchmark unaware funds. Managers of benchmark unaware funds will be less constrained by the need to deliver performance close to the benchmark over short time frames. As a consequence, these managers can focus on their best ideas without a need to dilute the potential returns through diversification.
• Consider concentrated managers. Concentrated portfolios eliminate or reduce a manager’s ability to ‘di-worsify’. A portfolio with limited names provides reduced opportunities for a fund manager to introduce portfolio fillers. Managers can be tempted to use portfolio fillers to reduce tracking error and thereby reduce relative performance risk. The problem with such action, as was pointed out above, is that by reducing relative performance risk, managers also reduce absolute performance potential and dilute their ability to add value through stock selection.

How can investors tap into these three sources of outperformance?

It is possible to tap into these the potential sources of outperformance, value, lower beta and concentrated portfolios, in the one fund.

The Tyndall Australian Share Concentrated strategy, launched in 2003, is a high conviction, concentrated Australian share portfolio comprising the best stock ideas identified through Tyndall’s proprietary research. The strategy invests in 15-25 stocks in the S&P/ASX 200 Index and is managed using Tyndall’s highly regarded and proven Intrinsic Value process.

The strategy’s performance objective is to provide long-term capital growth and income. To achieve this, the strategy seeks to invest in stocks that have a high total return but also a decent sustainable dividend yield.

The strategy has historically had a lower beta than the market (typically in a range of 0.75-0.90).

As illustrated in part 1 of this series, value investing has outperformed growth investing over the long term.  We are pleased to report that the Tyndall Australian Share Concentrated strategy has outperformed the Citigroup Value Index over the past 10 years as highlighted in chart 3.

A unit trust, which is managed using the same underlying strategy, was launched to the retail market in May 2010 and it ranked in the top 10 Australian share funds in the Mercer Survey in both 2012 and 2013.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Concentrated Fund (TASCF) ARSN 143 598 556 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (TAML). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. Reference to individual stocks in this material neither promise that the stocks will be incorporated into TASCF nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

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