Siren song of concentrated equity – and the risk of chasing returns

CONCENTRATED equity investing – allocating to discretionary strategies that hold a very small number of stocks – gained prominence more than a decade ago in response to performance pressures facing asset owners after the global financial crisis. While concentration was an intuitive response to a real problem, it also appeals to some of the most self-destructive behavioural vulnerabilities of investors.

In this column, we show how three of these vulnerabilities help to explain concentrated equity’s rise in popularity, and we bring to light underappreciated risks. But first, we set the stage by contrasting concentration in its ideal form with the reality of how it is often put into practice.

Concentration: the ideal and reality

Concentrated equity was a response to asset owners’ search for higher returns in a post-financial-crisis environment of low interest rates and scepticism that equity beta would suffice to meet ambitious performance targets. A rationale for concentration arose from the scrutiny of equity managers’ stock-picking prowess and what they were charging for it.

Academic literature from the late 2000s captured frustration with fees. It accused diversified discretionary managers of “closet indexing”, charging active fees for quasi-passive products by bloating their portfolios with stocks about which they knew little, simply to absorb assets under management.

Crucially, the foregoing motivations for investing in concentrated strategies do not imply that asset owners should hold an undiversified equity portfolio. They do not imply a rejection of diversification, just a shift in the locus of diversification from the investment manager(s) to the asset owner. The asset owner could select and construct a well-diversified collection of concentrated managers.

In assessing how well the concept of concentration translates into the real world, we pose three questions:

1. Do concentrated managers actually deliver superior stock-picking skill?

Unfortunately, our empirical analysis does not suggest that they do, as a group. In a broad study of US long-only institutional equity strategies from 2013 to 2023, we found no evidence that concentrated managers delivered higher alpha. The results do not imply that concentrated managers with exceptional stock-picking ability don’t exist. But they do suggest that asset owners should expect that they will have to work to find them, which begs a follow-on question.

2. Does implementing a concentrated allocation pose special challenges?

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Yes. In fact, concentration increases the difficulty of manager selection. That’s because, all else being equal, holding fewer stocks produces a return stream with higher active risk than a well-diversified portfolio. More noise means that it will take more data – a longer track record – to confirm the signal; that is, to conclude that the concentrated manager has alpha with any given degree of statistical confidence.

In addition, our empirical work showed how concentration presents challenges for risk control and performance analysis. Concentrated portfolios exhibit greater style drift, greater variation in risk exposures, and suboptimal trade-offs between drivers of outperformance, such as value and momentum. In addition to noisier returns, these characteristics likely reflect reliance on heuristic methods in portfolio construction.

3. Will asset owners actually implement a concentrated allocation in its ideal form?

Unfortunately, in our experience, the answer is “no”. Many investors who go down the path of concentration do not implement well-diversified allocations. Many hold narrow and biased collections of concentrated strategies, perhaps even a single manager or a few growthy ones. The allure of concentration and the tendency to under-diversify in its execution are hardly surprising, because both are tied to deeply rooted behavioural biases.

Preference for right skewness

One of these biases is a preference for right skewness.

For thousands of years, people have been drawn to lotteries – games that offer the possibility of a large pay-off – but where the chance of winning is small and paying to play is a losing proposition in the long term.

This bias is pervasive in investing, too. Academic research has documented investors’ willingness to pay up for assets whose return distributions have a “fat right tail”. The tendency helps to explain important patterns in asset pricing, including the low-volatility mispricing and the value premium.

There is a direct connection between the preference for right skewness and the allure of concentration. For a mean-variance investor, diversification is definitively a good thing in concept, because holding more stocks reduces risk (all else being equal). But that is not the case for an investor who wants a shot at an outsized pay-off: Diversification quickly tamps down the right tail of the return distribution.

But concentration may materially increase the risk of significant portfolio underperformance over the long term.

Empirically, more stocks have performed poorly than well in the long run, and a small number of stocks have accounted for a large portion of market gains. Holding fewer stocks may significantly increase the risk of missing out on the few exceptional winners, which increases the probability that any chosen concentrated portfolio will underperform.

This concern is especially relevant in a world where many benchmarks have become highly concentrated, driven by stellar returns of stocks such as the Magnificent Seven in the US and the Taiwan Semiconductor Manufacturing Company in emerging markets. Their conspicuous performance has helped to normalise the idea of holding just a few stocks, and growthy ones at that.

Ironically, however, the appropriate lesson is to diversify, because predicting in advance which few stocks will deliver stellar returns is an enormous challenge. You may get the theme right in many respects, yet still miss out on upside.

Disproportionate focus on “winners”

A second bias that helps to explain concentration’s allure and which influences its implementation is a disproportionate focus on “winners”.

The financial media, for example, lavishes attention on managers that have generated exceptional outperformance – until they don’t. Famous examples of lionised managers whose stars quickly fell include Bruce Berkowitz and Bill Miller. But fawning manager profiles and lists of rising stars – the 30 under 30, best-performing funds, and so on – make for enduringly effective clickbait.

Markets are noisy, and there are enough strategies in the marketplace that a decent number will throw off eye-catching track records simply due to luck. The hunger to find winners and the attendant willingness to believe ex-post stories that attribute outlying outperformance to skill generates interest in those managers and their investing approaches for unsound reasons. As a group, concentrated strategies are built to appeal to this bias.

Performance-chasing

Performance-chasing is another pervasive bias that plays into concentration and its under-diversified implementation.

This has behavioural roots. In addition, the staff at many institutions feel a powerful incentive to recommend investing styles and strategies that have been performing well; they see significant career risk in making idiosyncratic or contrarian calls that don’t work out.

There is little doubt that performance-chasing helps to explain many an implementation during the years in which concentration grew in popularity, when allocations were made to growthy, tech-oriented portfolios.

Moreover, managers cater to investors’ misguided backward-looking thematic interests – closet indexing is hardly the only manifestation of asset-gathering incentives gone awry. In the data-rich exchange-traded fund (ETF) space, academic research has documented that specialised and relatively high-cost ETFs, “tend to hold attention-grabbing and overvalued stocks and therefore underperform significantly…”.

Concentrated thematic investments in smaller, illiquid stocks exacerbate risks of chasing returns. As strong performance draws investor attention, new inflows may inflate prices, further boosting performance and drawing additional assets. This feedback loop poses risk to later investors, who are left holding the bag when the flow-driven price momentum abates and expectations reset.

A central lesson of behavioural finance is that investors should be ever watchful of behavioural biases and incentives that distort their decision-making. Concentrated equity makes for an especially powerful example, because this investing approach happens to be so well-suited to exploit those vulnerabilities.

The preference for right skewness, an asymmetric focus on winners, and performance-chasing help to explain concentration’s rise in popularity over the past decade, and have influenced how it has been implemented. But we see these dangerous influences at work in many investing contexts. Stay vigilant.

The writer is director, client advisory, Acadian Asset Management