To judge a managers investing acumen, look at how diversified they are.
Skillful active managers should and actually do hold more concentrated portfolios, according to a recent research paper from the University of Texas at Austin and University at Buffalo.
The more alpha or excess return over a benchmark index that a manager produces, the fewer positions they hold, found co-authors Keith Brown of the University of Texas at Austin, Christian Tiu of University at Buffalo and Uzi Yoeli, a managing director at the University of Texas Investment Management Co. For every 10 basis points in monthly alpha that a manager earned above the average actively managed fund, that managers portfolio held five fewer stocks, according to their findings.
It is the superior skill of the manager that leads to the decision to form a concentrated portfolio in the first place, the researchers wrote in the paper. It is ultimately the managers selection skill and not the composition of the portfolio per se that generates subsequent investment outperformance.
For the study, the trio first constructed a simulation based on actual return data of U.S. stocks. They found that the optimal portfolio composition changed dramatically when skill was taken into account. Although the optimal portfolio for an unskilled manager was fully diversified, a manager with even the most modest skill would invest in only 15 percent of the stock universe a figure that declined to as low as 6 percent as manager skill increased.
The authors then examined the holdings and performance of 4,223 mutual fund portfolios between January 2002 and March 2015, finding a highly statistically significant relationship between skill and portfolio composition.
[II Deep Dive: How Not to Be Wall Streets Sucker]
External asset owners cannot observe a managers skill level directly, but they can observe the size and composition of the portfolio that he or she forms, the authors wrote. Investors are well served by selecting genuinely skilled fund managers who hold portfolios that are less than fully diversified.
Although they acknowledged the possibility that less skilled managers could build a concentrated portfolio in order to suggest a higher level of ability, the authors found no evidence of this occurring in the sample they studied. This means that concentration may be a reliable proxy for manager skill.
The challenge for the investor, they said, is to identify those superior managers in advance and then encourage them to restrict their portfolio holdings by focusing on their highest-conviction ideas.