The Decision to Concentrate: Active Management, Manager Skill, and Portfolio Size

Abstract

Recent research shows that more highly concentrated portfolios produce superior risk-adjusted returns. The untested premise is that it is the most skillful managers who hold the most concentrated portfolios. In this article, the authors formally examine the implicit assertion that the initial portfolio concentration decision is related to a manager’s inherent investment skill. First, they present a theoretical model indicating that the greater the manager’s skill level, the more concentrated the portfolio should be. Second, they conduct a simulation analysis of the capacity to make accurate ex ante security return forecasts; they show that skilled managers would select as few as 5% of the available securities and that the portfolio concentration decision is directly proportional to investment prowess. Finally, they provide an empirical examination of the actual skill–concentration relationship for actively managed equity mutual funds over 2002–2015 and document that managers who demonstrated past skill do form portfolios with higher concentration levels. The authors conclude that talented asset managers should and actually do hold more concentrated portfolios and that the extent of this concentration decision is meaningfully related to forecasting skill.

TOPICS: Manager selection, mutual fund performance, equity portfolio management

Key Findings

• • The authors analyze the level of skill that an active manager must have to justify the decision to form a concentrated set of security holdings rather than a broadly diversified portfolio.

• • Using a conceptual model and a simulation, they establish a strong direct connection between a manager’s forecasting talent and the portfolio concentration decision. Optimal portfolio sizes decline to as little as 5% of the investable universe with increasing skill.

• • The authors develop three portfolio concentration measures and demonstrate with an extensive set of historical mutual fund returns that managers with the best past performance do indeed hold the most concentrated portfolios over time.