A recent study by a team at Vanguard contradicts the idea adopted by many investors and financial professionals that “broadly diversified portfolios are inferior to concentrated portfolios made up of a manager’s ‘best ideas.’ “

While the underlying premise might make sense—that performance of a manager’s most promising holdings would outperform those with a weaker outlook—the Vanguard paper makes an extensive and detailed case as to why the argument doesn’t hold up. Here are some highlights:

  • The premise reflects hindsight bias and therefore “obscures the difficulty of identifying a portfolio’s best ideas.”
  • Using thousands of portfolio simulations, Vanguard evaluated the correlation between portfolio diversification and outperformance and found that increasing concentration lowers rather than increases outperformance odds.
  • The study found that it can be difficult to discern what a manager’s best ideas were if, for example, a manager is (1) skilled at adding to more profitable positions over time—in which case the “best idea” is less of a permanent situation than a dynamic one; (2) is good at cutting back on losing positions; or (3) “best ideas” involve significant risk such that the manager keeps the position small.
  • “The less diversified a portfolio, the less likely it is to hold the small percentage of stocks that account for most of the market’s long-term return.”
  • Vanguard’s analysis concludes that a manager must meet two metrics in order to outperform the market: the “excess return hurdle,” and the “success rate,” defined as follows:
    • Excess return hurdle is the anticipated gap between portfolio and market returns at different levels of concentration (which Vanguard’s study shows decreases with increased holdings);
    • Success rate measures the manager’s ability to identify outperformers. The level necessary for outperformance, according to Vanguard, decreases as the number of holdings increases.
  • On diversification, the paper notes, “whether the majority of the performance of active managers is driven by skill or luck is a question beyond our research scope.” It argues, however, that probability theory—which says “if you have a small edge, that edge can be amplified by making more bets, not fewer”—dictates that an above-average manager should make as many bets as possible. “Probability theory,” the paper says, “highlights flaws in the common claim that diversified strategies lack conviction and are benchmark-huggers. These strategies can more appropriately be described as an effort to maximize the benefits of a persistent edge.”

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