AASHISH SOMAIYAA | Tue, 5 Jul 2016-06:35am | dna
Do you know why technology giant Apple has been able to earn the numero uno position among its peers and scale new peaks every year? It was a result of a small change which won big results for the company.
When Steve Jobs took over reins the second time around, he shrunk the company’s product basket to five core products as he felt that lighter the product bouquet the faster the company would be able to sprint.
Critics would claim that a limited product basket increases the chances of heavy losses if even one product fails to click with buyers. But Jobs proved them wrong and he wasn’t the only one to follow a focused approach.
Legendary tales of the focused approach are often recounted in the world of equity investments too. Celebrated equity investor Warren Buffett has demonstrated the miracle of betting on few horses than is usually advocated.
The top five investments made up nearly 65% of his total portfolio.
But aren’t lay investors incessantly nudged not to put all eggs in one basket? Well, results thrown up by our research concludes that splitting the eggs in too many baskets – also termed as diversification in – doesn’t always reduce the risk.
Putting all your eggs in the same basket means you should have identified the right basket and you should work overtime to ensure that basket is safe. On the other hand, putting your eggs into too many baskets in the name of diversification puts an onus on you to identify many more baskets.
The study of risk associated with open-ended equity schemes measured using standard deviation strongly points out that a broader portfolio doesn’t reduce risk. Standard deviation captures the performance swings of a scheme. The higher the fluctuations in a fund’s returns the greater will be its standard deviation. So, if a fund has an average return of 15% with a standard deviation of 4% then most of the times the returns of the fund would be between 11% (15%-4%) and 19% (15% +4%).
For the ease of comprehension, we call the schemes that held less than 25 stocks as focused, the ones that held 25-50 stocks as diversified and those beyond 50 stocks as over-diversified (they should be really called “spray-and-pray” because no one can profess to thoroughly conduct bottom-up research on over 50 companies at the same time).
The data shows that focused or concentrated portfolios (having less than 25 stocks) have generated higher average returns and their standard deviation as a measure of volatility is not significantly higher than the other schemes. On the other hand, there’s nothing to really pick between schemes that were supposedly diversified and had between 25 to 50 and over 50 stocks as two separate groups. In fact, the average return for >50 group is same as the 25-50 group and there is no decline in standard deviation as a measure of volatility.
If we peg this standard deviation against the returns, we realise that there is more to gain by following a focused equity strategy. Concentrated equity schemes delivered better returns and were even able to curtail the downside during the shorter period as compared with the mixed bag schemes. In turn, these mixed bags were able to steer past equity schemes that had a larger universe of stocks.
What is ailing diversified schemes? They are facing what can be termed a problem of plenty. Splitting the apples into too many baskets forces the fund manager to spend more time on monitoring each basket rather than picking up the right apples.
If the fund manager has fewer stocks to scrutinise day-in-day-out and track monthly toplines and quarterly results, he would be able to allocate more time to cherrypick the right horse that would lead him to victory. We all know one cannot change a horse mid-race.
This impact of concentration on portfolio returns has been studied by several analysts. Most recently, Joop Huij and Jeroen Derwall analysed the performance of 536 global equity funds over the period of 1995-2007 and noted their findings in the report ‘Global Equity Fund Performance, Portfolio Concentration, and the Fundamental Law of Active Management.’ They concluded, “Evidence from US equity mutual funds suggests that fund managers who are willing to take big bets and hold more concentrated portfolios display better performance than managers who hold more broadly diversified portfolios.”
It is worth noting here that a fund house widened the cap of 30 stocks held by its focused scheme in 2010 to accommodate 50 stocks. The performance of the scheme among its peers slipped ever since it expanded its portfolio.
The reason is simple. If you have a limited basket to invest you would place your best bets only after doing adequate research as one wrong move could abysmally impact the returns. One can draw similarities between a fund manager and a gardener, who has to choose a handful of plants for the given area. He would always handpicked the most rewarding plants leaving out the rest as he wouldn’t want the fertility and his efforts to be wasted on plants, which merely occupy space.
Similarly, a focused scheme’s fund manager would dive in only if he is convinced about the business. He/she would be privy to superior information about specific market segments and players. He would then invest and nurture for long them to bear the fruits. Unless he sows a higher area (read high concentration in stocks), he won’t be able to multiply the profits well.
As the Oracle of Omaha, who detested diversification, once said, “Wide diversification is only required when investors do not understand what they are doing.”
Now that you are convinced about the focused fund’s strategy, don’t just jump into any scheme. Analyse whether the portfolio is suitably invested across sectors to protect your investment from business-cycle related liquidity issues which could drag your portfolio returns. As Huij and Derwall point out in their report, “Funds with a high tracking-error level outperform only when they are concentrated in multiple market segments simultaneously.”
The writer is CEO of Motilal Oswal AMC