The last two decades have seen a dramatic migration of US and global equity investors toward passive approaches, especially in large-cap stocks. Passive investing may be cheaper on the surface, but we think investors are taking on more risk than they know. We think it makes sense to combine passive strategies with highly concentrated strategies.

But it’s fair to ask pointed questions about how the two approaches stack up. It’s a common assumption that the more stocks you add to an equity portfolio, the more it reduces volatility. But beyond a threshold of 20 to 30 stocks, it gets more challenging to meaningfully reduce tracking error (Display below). This leaves a strong case to be made for quality of stocks, not quantity, in portfolio construction. By using research to focus on fewer but higher-quality stocks, concentrated investing has the potential to produce substantial alpha through security selection.

Our research shows that "concentrated" active managers have been very successful in terms of excess returns and risk-adjusted returns as well as downside risk reduction. Concentrated investing may also be an effective complement to passive investing.

There's a strong case to be made for quality of stocks, not quantity, in portfolio construction

 

To put numbers to this concept, we categorized US equity managers based on the number of positions they hold. We'll call managers with 35 or fewer stocks “concentrated” active managers. These managers tend to have very high "active share".

Managers with 36 to 200 stocks can be referred to as "traditional" active managers. As a group, they have a fairly high active share, but it varies greatly within the category. Managers with more than 200 stocks are effectively "passive" investors with low active share.

Historically, concentrated managers have been very successful. The median concentrated manager has delivered 3.32% annualized rolling excess returns over the last five years and 3.76% over 10 years, gross of fees (Display below). Traditional managers have also produced excess returns, though lower than those of concen¬trated managers (1.80% over five years and 1.90% over 10 years). Passive managers have posted relatively flat excess returns over both time periods. Sometimes, there’s power in fewer stock holdings.