As the old adage goes, one must concentrate to build wealth and then diversify to protect wealth. However, the benefits of diversification can diminish rapidly after you reach around 30 stocks.
This concept can be traced back to a paper published by Lawrence Fisher and James Lorie in 1970, which showed that 95% of the benefit of diversification could be captured by a randomly created portfolio of 32 stocks.
“So perhaps investors should think about concentration,” says Kamal Warraich, head of equity research at Canaccord Genuity Wealth Management. He adds: “An important caveat is that investors should focus on the ‘best’ 30 stocks they can find.”
The main advantage of a concentrated portfolio is its potential to generate outperformance. The flipside of this is the prospect of elevated volatility and steeper drawdowns.
David Liddell, a director at IpsoFacto Investor, notes: “Concentrated portfolios will generally not perform in line with indices – a positive point for those seeking alpha. It may also be true that concentrated portfolios impose selection discipline on fund managers versus a more diversified portfolio.”
As interactive investor investment analyst Alex Watts points out, concentration risk can make for a bumpy ride as the performance of one holding has a large effect on the overall portfolio return.
“Sectoral concentration can lead to cyclicality of a fund’s performance resulting from macroeconomic conditions,” he adds.
However, counterintuitively, a concentrated portfolio may carry less stock-specific risk because it allows for closer and more thorough research of each position at a company level.
“The whole point about concentration is that you can spend much more time analysing fewer companies, and although it sounds contradictory, you might actually reduce idiosyncratic risk this way,” says Warraich.
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A concentrated portfolio has fewer positions from which to draw liquidity if required – something that investment trusts with their permanent pool of capital need not worry about.
“We see the investment trust structure as being very well suited to a concentrated approach as it’s not subject to the potentially disruptive impact of daily subscriptions or redemptions,” says Peel Hunt analyst Anthony Leatham.
It comes as little surprise, therefore, that when asked to name their favourite punchy portfolios professional investors suggested twice as many trusts than funds.
Before we look at them, though, it is worth making two further points about portfolio concentration.
First, says Watts, concentrated portfolios may still derive diversification from geographic, sectoral or stylistic variety, and at times may even allocate in a more balanced manner than indices driven by market-cap weighting. “Concentration and diversification are not necessarily mutually exclusive,” he says.
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Second, stresses Ben Yearsley, investment director at Shore Financial Planning, concentration shouldn’t be looked at in isolation.
“You could own just 10 stocks, but if they mirror the world’s 10 largest companies, you’d probably be better off buying a tracker fund,” he says. “Active risk [differentiation from the index] is the key. Having a few stocks doesn’t necessarily mean you’ll get this and having a large number doesn’t mean you won’t.”
With all that in mind, let’s take a look at the pros’ 11 picks.
The most-popular fund among interactive investor customers is a focused portfolio of 20 to 30 stocks. Rated by the analyst team, this Super 60 fund looks to run its winners. Smith targets high-quality companies that have strong competitive advantages. Fundsmith Equity currently has 27 holdings, which include Novo Nordisk A/S ADR (NYSE:NVO), Microsoft Corp (NASDAQ:MSFT) and L'Oreal SA (EURONEXT:OR).
Martin Currie Global Portfolio
Another concentrated global fund, suggested by Kepler Trust Intelligence, is Martin Currie Global Portfolio Ord (LSE:MNP), which has 25 to 30 holdings.
Research analyst Nicholas Todd says: “This high-conviction, growth focused approach, and the trust’s structural approach to gearing can require a strong stomach during shorter-term periods of enhanced volatility. However, this can also lead to period of exceptional outperformance as it did in 2020 and this year to date.”
LF Lindsell Train UK Equity
A veteran stockpicker Yearsley favours is Nick Train whose WS Lindsell Train UK Equity fund holds as little as 20 stocks. “He’s definitely a long-term investor,” says Yearsley. He points to the incidence of concentrated funds like Train’s taking a quality growth approach. “Maybe that’s because there’s less risk of total loss compared to say a value or recovery approach where a company might go bust,” says Yearsley.
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Temple Bar (LSE:TMPL) holds around 30 deeply unloved UK stocks. Liddell added it to IpsoFacto’s mainstream investment trust portfolio in February 2021 following a turbulent time that saw it change management to RWC Asset Management. “Although not everything has worked out, the likes of Centrica (LSE:CNA), Marks & Spencer Group (LSE:MKS) and the oil majors have helped the trust outperform and the dividend should grow quite rapidly from here,” he says.
Kepler Trust Intelligence rates Rockwood Strategic (LSE:RKW). Manager Richard Staveley takes a valuation-focused approach to pick around 20 companies from the smallest end of the market. “This concentration affords Richard the time to create a full investment case for each stock, as well as planning an exit strategy, which helps the liquidity concerns associated with the area,” says research analyst Ryan Lightfoot-Aminoff.
European Opportunities Trust
QuotedData and Shore Financial Planning both like European Opportunities Trust (LSE:EOT) with its portfolio of around 30 European “special” companies.
“These are niche winners in their respective fields that can flourish in a range of economic scenarios,” says QuotedData senior analyst Matthew Read.
Yearsley points to the trust being burned by the failure of Wirecard a few years ago, but continues to rate manager Alexander Darwall (pictured) of Devon Equity Management. “Though many deserted him, I like his simplistic approach of looking for good quality growing businesses,” he says.
Man GLG Continental European Growth
For long-term investors, Man GLG Continental European Growth holds a spot on interactive investor’s Super 60 investment ideas' list. Its managers run a portfolio of around 25 names with substantial stock and sector concentration.
“The merits of the sectoral concentration have been exhibited recently with the bold call in favour of consumer discretionary names, including Ferrari NV (MTA:RACE), LVMH Moet Hennessy Louis Vuitton SE (EURONEXT:MC) and Hermes International SA (EURONEXT:RMS), driving stellar returns in the year to date,” says Watts.
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Brown Advisory US Sustainable Growth
“The fund is a consistent long-term outperformer on an absolute and risk-adjusted basis aided by the long-held concentration in the technology and healthcare sectors, with names such as Danaher Corp (NYSE:DHR), Microsoft and Intuit Inc (NASDAQ:INTU) proving strong investments,” says Watts.
AVI Japan Opportunity
On to Japan now, and QuotedData favours AVI Japan Opportunity (LSE:AJOT), which typically owns 25 to 30 quality Japanese small-caps.
Read says: “As is common in Japan, these will have a large portion of their market capitalisation in cash, listed securities or other realisable assets. The manager engages proactively with these companies, aiming to unlock the significant value tied up in them, assisted by a strong trend of improving corporate governance in Japan.”
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CC Japan Income & Growth
Peel Hunt likes all-cap strategy CC Japan Income & Growth (LSE:CCJI), which currently has 40 holdings. “It was the first dedicated income strategy in the sector and, while the portfolio is concentrated by the number of holdings, the manager has been able to blend different types of dividend stocks across stable yield, dividend growth and special situations,” says Leatham.
Mobius Investment Trust
For the final choice, Peel Hunt flags Mobius Investment Trust (LSE:MMIT) and its high-conviction portfolio of 27 small to mid-cap companies across emerging and frontier markets. “The concentrated portfolio not only reveals the high conviction but also allows the team to deliver a bespoke engagement strategy for each company,” says Leatham. “This is a very stock-specific approach and requires deep due diligence and almost a private-equity mindset to value creation, hence the concentration works to its advantage.”
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