Since the beginning of index investing nearly 50 years ago, the debate on active and passive equity management has raged with no end in sight. As the institutional money management industry has grown and come to represent a majority of assets, the average money manager has, unsurprisingly, been unable to beat the market, leading some investors to index their equity exposure.

At the same time, there are many investors who seem to defy the odds and consistently land in the top performance deciles among their peers. While simple math tells us that it is impossible for the average active manager to outperform a market in which the manager represents a majority of the assets, we also believe most active investors make several systematic errors that doom them to mediocre long-term investment results.

One of these errors is the overdiversification of their portfolios. At Brown Brothers Harriman (BBH), we believe in the value that carefully chosen active investors can add to our clients’ portfolios. As such, active share, a holdings-based metric that can be interpreted as the percentage of a portfolio that differs from its index,¹ is one figure we focus on to help guide us in our investment decision-making.

The Concept of Active Share
For years, researchers have strived to identify inefficiencies that can be exploited to generate superior investment performance in what, most of the time, are relatively efficient financial markets. While the majority of studies fall short of offering any useful information that will stand the test of time, researchers have more recently shifted gears and attempted to explain why the minority of funds that do outperform are successful.

Among these studies, a landmark 2006 paper from the Yale International Center for Finance that coined the term “active share” convincingly demonstrated a glaring weakness in the U.S. mutual fund industry: Overdiversified funds, or more specifically, funds with a low active share, significantly underperformed their high active share counterparts.² These overly diversified “closet index funds,” as the authors of the study call them, which are managed more for the benefit of their parent firm than the underlying investors, are one of the more notable black eyes on the fund management industry.

Research on Concentration
Funds with less than 60% active share³ had few assets before 1997 but became prominent in the early 2000s. More recently, according to research, the percentage of assets in funds with less than 60% active share steadily declined to about 12% at the end of 2015.⁴ However, this decrease in low active share funds did not reverse the broader trend toward lower active share in a sample of U.S. retail mutual funds with at least $10 million in assets under management from 1990 to 2015. In particular, the percentage of assets in funds with active share above 80% and 90% remained fairly stable between 2006 and 2015 at around 30% and 10%, respectively. Why does this matter? The study found that as a group, low active share funds (that is, those in the bottom quintile) substantially underperformed their benchmarks by 1.37% per year. The finding is strongest among small-cap managers but is also significant for large-cap funds. While anyone can simply purchase a small number of stocks, we believe this study shows that the decision by a mutual fund manager to concentrate purchases is often a signal of manager skill.

The biggest problem with low active share funds is that they charge fees comparable to other active managers, but, because of their overdiversification, it is improbable that their performance will ever differ materially from their respective index. After calculating the active share metric across the universe of registered mutual funds, it is clear that a large portion of U.S. equity mutual funds charge active management fees for undifferentiated portfolios, and as expected, the study finds that these closet indexers as a group largely match the performance of their benchmark indices before fees and expenses. These managers’ clients are thus doomed from the start: After fees and expenses, which is what matters for clients, these funds are almost certain to underperform their benchmark indices.

Other research supports the notion that concentrated stock portfolios comprising a manager’s highest conviction positions are more likely to outperform. In a 2005 paper titled “Best Ideas,” the authors identified, ex ante, which positions in fund managers’ portfolios were their “best ideas” by looking at position weights relative to their benchmark. They found that “best ideas not only generate statistically and economically significant risk-adjusted returns over time, but they also systematically outperform the rest of the positions in managers’ portfolios.”⁵ The level of outperformance varied between 1.6% and 2.6% per quarter depending on what factors were used to risk-adjust the returns. The authors postulated that the remaining positions that a fund owned were low-conviction ideas that served mainly to reduce tracking error vs. the fund manager’s index.⁶

Another study on fund managers with concentrated stock positions found that, on average, the managers outperformed their more broadly diversified peers by roughly 4% per year.⁷ The research also found that these managers’ outperformance could be traced specifically to their biggest bets, and their results suggested that a portfolio comprising several concentrated managers would outperform a highly diversified portfolio from a single manager.

Overall, the body of research on concentration supports the notion that active stock pickers as a group possess real skill; however, this skill is diluted by the holding of low-conviction positions that may have resulted in needless diversification. As to why so many managers choose to engage in a game where the odds are stacked against them, in many cases, their actions may simply reflect their intent to maximize fee revenue as opposed to performance.

As Charles Ellis points out in “The Rise and Fall of Performance Investing,” most large managers, because of their size, are unable to run concentrated portfolios and are forced to “invest primarily in the 300 stocks most widely owned and closely covered by experienced portfolio managers and expert analysts.”⁸ In other words, much of this overdiversification is simply the result of institutional constraints that are imposed on the portfolio management process by fund management companies.

While concentrated portfolios tend to outperform over time, they also lead to tighter capacity constraints on fund size, which limit the manager’s ability to grow their fee revenue. Concentrated funds are also subject to more volatility, and since many funds are judged, in our view inappropriately, on metrics such as Sharpe ratio,⁹ reducing volatility vs. a benchmark can make the fund look more attractive to certain audiences.

Lastly, fund managers are more likely to get fired when they drastically underperform their benchmarks, so “rounding out” their portfolios with low-conviction positions helps reduce this potential risk.

Other Benefits of Concentration
Leaving aside for a moment the empirical evidence on active share, there are other logical reasons for owning concentrated portfolios. While behavioral finance theory may seem to suggest that concentration could be a sign of overconfidence, in reality, the literature on this topic suggests that high levels of trading activity, something we actively avoid, are more closely associated with overconfidence. Concentration, in our view, is many times a sign of humility – a trait that we value greatly in managers.

As Warren Buffett said perfectly in his 1996 Chairman’s Letter:

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

The concentrated managers that we believe are differentiated have a keen understanding of their circle of competence and have the discipline to stay inside their circle, which is what gives them the conviction to hold large positions. The level of rigor in fundamental research required to have this conviction provides a steep hurdle to managing a concentrated portfolio, which we like.

Another rationale for holding concentrated portfolios is simply that good investments are hard to find. A manager diligently looking for opportunities within its circle of competence in markets that are efficient much of the time may only find a few opportunities to invest each year. When a manager does find an opportunity that meets its criteria, we prefer that it holds a substantial position in that investment.

BBH’s View
As our clients know, one of our primary risk management techniques is insisting on knowing what we own and why we own it, and this is well aligned with how most concentrated portfolios are managed. In our view, a portfolio should contain only as many ideas as can be thoroughly researched. The ability to focus on a smaller number of companies is a competitive advantage for concentrated managers vs. other more diversified funds and is also one of the more effective ways of managing risk. As a manager we respect once said:

Our strategy is to concentrate in our best investment ideas – the ones we believe are the safest, highest-return places for our capital. Investment safety is a function of solid research, rational thinking, financial strength, durable competitive position, and valuation. While a widely diversified portfolio may feel safer as it closely tracks the market, it will not necessarily protect your principal or grow your wealth. As the fund’s largest investors, we greatly prefer a bumpy ride to paradise over a smooth ride to nowheresville.

We would rather build a portfolio by allocating capital to several concentrated managers who invest only in their best ideas than by investing with managers who dilute their best thinking in order to manage volatility relative to a benchmark.

Conclusion
We believe investing with managers who hold concentrated investments in their highest conviction ideas increases our chances of earning attractive long-term returns for our clients, while the manager’s deep research of each position also serves to reduce the risk of permanently impairing capital. Not only is this way of investing highly logical, but also supported by empirical evidence. While active share is only one metric we look at in our manager selection process, failure to realize its importance can doom a portfolio to mediocre results.