The Right Answer for Portfolio Management
April 16, 2021
Steve Essex, CFP, CTFA
Debates continue about the best way to manage an investment portfolio. Regardless of one’s investment preference, there are convincing arguments for both diversified as well as concentrated strategies. The investing public doesn’t hear often enough that there is no single answer for what approach will have the best chance for success. It really depends on the investor’s particular time frame and, importantly, their requirements for distributions. The purpose to this article is to provide a high-level overview of the basic arguments we hear often in our discussions with clients and other advisors, and to provide a sense for where we stand.
As we tell our clients, the development of an investment strategy needs to begin with fully considering risk tolerance and risk capacity. Regardless of the client responses to these questions, investing in anything beyond certificate of deposit instruments and other cash equivalents should not be considered for those funds that may be needed in the near term. This is a difficult point to make when short term rates are under 1% annually – an environment that pushes many to consider taking on more risk for higher returns. The issue is that taking that risk might jeopardize an investor’s ability to meet short-term cash flow commitments. The challenge is to determine a level of comfort in relation to taking investment risk (tolerance) and balancing that answer with what risk may be afforded (capacity).
Thinking About a Concentrated Portfolio?
There’s a commonly referenced quote by Warren Buffett, “Diversification is protection against ignorance. It makes little sense for those who know what they’re doing”. As with similar arguments, a response may be, “Yes, but…” For those investors with the ability to fully dedicate funds for long term investment, perhaps a decade or more with little chance of needing access to the principal, a concentrated portfolio may be an option. There are advantages to this approach but no shortage of accompanying risk.
A concentrated portfolio of stocks, also referred to as a “high conviction portfolio”, may have a limited number of companies, perhaps less than 30 and often about half that amount. It has been found that most of the benefits of diversification can be achieved in a portfolio holding 25 to 30 stocks, with 83% of this same benefit achieved with a portfolio of 10 stocks.12 It’s important to note, if one is concerned about managing risk and volatility with this approach they should be conscious of the correlation between a limited number of positions.3 Just as in a diversified portfolio, the investor would rather not have all holdings always move in the same direction, to the same degree, at the same time.
Just as you may expect, an account with a limited number of holdings will likely experience greater swings in market value than a diversified portfolio. The higher volatility may not be an issue if there exists a long-term investment timeframe and if there is no need for distributions. Distributions, including account expenses, fees and taxes, introduce what is called “sequence of returns risk” which is the risk to a portfolio created by the order of positive and negative returns. Without distributions, the order of returns over the investment timeframe doesn’t matter. Periodic outflows may have a significant impact on performance.4
Once the risks are considered, if the investor wishes to pursue a high conviction strategy they may benefit by focusing attention on a handful of companies. It makes sense that the investor or manager would know those holdings well, may have an opportunity to invest in companies at attractive values or which are mispriced, and therefore would have an opportunity to outperform market returns over time. This approach takes a great degree of skill, resources and expertise which is hard to find. Essentially, concentrated portfolios are not for irresolute investors but the strategy may reward those who are comfortable with, and who can afford the risks.
How About Diversification?
A well-diversified stock portfolio is invested in many companies across multiple asset classes and sectors, likely to include global market exposure. Diversification provides protection against the decline in market value of any one or handful of companies, which is front and center in concentrated portfolios. A greater number of holdings and broad exposure therefore helps to lower volatility to counter the “sequence of returns” risk previously mentioned.
Within diversified investment strategies, investments may be either actively or passively managed. A passive portfolio is one constructed of index funds for exposure to various asset classes, which are designed to match the performance of desired benchmarks like the S&P 500, Barclays Aggregate Bond Index, Russell 2000 or MSCI EAFE. Over the past decade, there has been a substantial movement of investment dollars to low cost index funds as the passive investment movement gained momentum. This may have been largely influenced through the statistics which show that few actively managed funds consistently outperform their benchmark over time, while an index fund will track and therefore mostly match the performance of the benchmark. The argument is for a preference for benchmark returns vs. a “fool’s errand” of trying to consistently outperform the market.
This seems on the face of it to be a solid conclusion and may lead one to want to use passive investment strategies in every instance if it were not for a common desire to protect against market downturns. A passive portfolio can be expected to fully capture a pullback in the markets and like the concentrated approach, creates a greater exposure to the sequence of returns risk if distributions are needed, which most often is the case. In my reading for this article I have not been able to find a study to show the relative performance of a passive vs active portfolio which considers withdrawals and management expenses. In Salisbury Trust’s role as a manager of trusts, this is unfortunate given how a passive approach would otherwise seem to fit with the requirements of a trustee to keep expenses at a minimum, diversify and provide for liquidity, but the passive approach still has a place with certain investors who may have a longer-term time horizon for part of their investable assets.
Active management refers to an account, investments or funds managed to proactively respond to performance of the holdings, and changes in the economy and the markets. With active management, there is the ability to choose holdings and managers to adjust to a constantly developing investment environment. Therefore, it is possible to minimize a decline in a portfolio’s value during a market downturn through reallocation or by replacing a specific investment which is no longer attractive. While active management may help lower the intensity of a drop-in market value, a point sometimes made by proponents of concentrated strategies is that many actively managed funds or accounts are over-diversified (also referred to as “deworsification”). The argument here is that there are too many holdings, either individual positions or within funds, used in an effort to minimize volatility to an extent where one might as well be in a passively invested index portfolio. There is a middle road, however, which may include both an active and passive strategy.
The advantage of risk reduction which accounts for distributions may outweigh the downside and lesser chance of reaping the returns possible in a well-managed concentrated portfolio or experiencing the full impact of a market downturn in an entirely passive approach.
Whether one investment strategy is appropriate over another is largely determined by time horizon, risk tolerance and risk capacity, and may be highly dependent upon market conditions over the investment timeframe if portfolio distributions are needed. If one has a rare talent for selecting undervalued companies (or one can find a manager with a solid track record at a reasonable fee), if they have a high tolerance for investment risk and capacity to take that risk, and a long investment time horizon with no need to access the investment principal, one could consider a concentrated portfolio for a portion of their assets. For someone who prefers lesser volatility provided by diversification and can weather a down market without needing access to principal, a passively invested portfolio may be considered. In our experience with clients here at Salisbury Trust, an actively managed diversified portfolio is preferred for a majority of investors to protect against market downturns and to preserve principal as distributions are taken. There is no single right answer to which investment strategy is best for all cases but there is a right answer for the appropriate strategy for each client. It all starts with our conversation.
1 John Evans & Stephen Archer – “Diversification and the Reduction of Dispersion; an Empirical Analysis”, 1968
2 C Thomas Howard, PhD, “Concentrated Equity TriplePlay; Higher Returns, Lower Risk, Lower Correlations”, Advisor Perspectives, March 13, 2012
3 Harry Markowitz – “Portfolio Selection”, Journal of Finance, Vol. 7 No. 1. March 1952
4 Michael Kitces – “Understanding Sequence of Return Risk – Safe Withdrawal Rates, Bear Market Crashes, and Bad Decades” – www.kitces.com/blog, October 1, 2014
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