Funds and investment trusts with the punchiest portfolios

David Prosser runs through the risks and rewards of funds and trusts that bet big with single-stock positions.

When is a collective investment fund not a collective investment fund? One answer to that riddle might be when the fund is invested very heavily in a single stock, or a small number of them.

After all, the whole point of a fund is that even a small investment gives you exposure to a broad basket of holdings and the diversification benefits that such a spread can bring. If you’re actually very heavily exposed to the fortunes of a single holding, what’s the use of the fund approach?

It’s a concern that has not been lost on investors in Baillie Gifford funds over the past few months. For much of the past two or three years, Baillie Gifford’s funds and investment trusts, including its flagship Scottish Mortgage (LSE:SMT), have posted stellar performances thanks to their large holdings in a number of high-flying stocks in the technology and pharmaceutical sectors – including Moderna (NASDAQ:MRNA), Illumina (NASDAQ:ILMN), Zoom (NASDAQ:ZM), Shopify (NYSE:SHOP) and Netflx (NASDAQ:NFLX).

In the final quarter of 2021, however, those stocks went into reverse and that has continued in 2022. All five of the companies above lost over 25% of their value between August last year and February. Baillie Gifford’s funds tumbled accordingly – and many investors ran for the hills; Morningstar’s data suggests investors withdrew £875 million from the firm’s funds in January alone.

Still, Baillie Gifford is far from unique in following a concentrated approach to portfolio selection. As table one shows, almost 20 investment trusts hold more than 10% of their assets in a single stock, with Lindsell Train Investment Trust (LSE:LTI) topping the table, with close to half its assets in its fund management business – Lindsell Train Limited.

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While Morningstar does not collate single-stock data for open-ended funds, where regulation imposes stricter limits on the size of individual exposures, table two reveals 10 funds that hold at least 60% of their assets in their top 10 holdings.

The European Union’s UCITS rules, a regulatory framework for funds sold to investors in Europe, stipulate that holdings accounting for more than 5% of a fund’s portfolio cannot collectively account for more than 40% of the fund's overall holdings. At the same time, UK fund rules prohibit an individual holding exceeding 10% of fund’s total assets. Investment trusts, however, do not have a 10% limit.

Should investors worry about such an approach to investment?

One danger of concentration is increased volatility. When the favoured stocks are performing well, the fund races ahead, not held back by more lacklustre holdings; the downside is that there is less of a cushion to protect investors when these large holdings are on the slide.

Scottish Mortgage’s performance history proves the point. It made gains of 121% over the course of 2020 and 2021, according to Morningstar. This year it is down 18.6%.

Dzmitry Lipski, head of funds research at interactive investor, is one analyst for whom the potential for this kind of volatility is a worry.

“We consistently emphasise that taking too much risk and investing in just one asset could mean losing money if you get it wrong,” he says. “We see time and time again that diversity is key: because of this, we would generally say that investors should carefully think about any single stock which accounts for a large chunk of a fund’s portfolio.”

Equally, however, financial advisers such as Ben Yearsley, investment director of Shore Financial Planning, point out that when we pay fund managers’ fees, we’re effectively asking them to make decisions on our behalf – unless it’s a cut-price passive fund that simply tracks in index.

“Having too much diversification is not your friend,” Yearsley argues. “In active funds, if you are over diversified, you might as well buy a much cheaper tracker.”

Indeed, the concept of high-conviction investment has gathered pace in recent years. If you’re paying an annual management fee that is, say, 10 times’ higher than what a low-cost passive fund would charge, there’s a case for spending it with a manager who has the courage of their convictions.

Still, Yearsley has a caveat here. “Conviction isn’t just about having large holdings; it’s also about being different to the index,” he says. Rather than getting too hung up on portfolio percentages, he suggests looking at a more telling number.

“The ‘active share’ number is the one I’d concentrate on,” Yearsley explains. “This shows you how a fund differs to the index: an active share of 100% shows you it’s totally different, whereas 1% means it’s basically the same. A 20-stock portfolio could have a lower active share than a 200-stock portfolio.”

High active share not a panacea

High active share funds do not guarantee superior performance – despite some claims to the contrary when the statistic was first introduced by two academics from Yale Business School 15 years ago. The number is simply an indication of whether an active manager is making brave and independent decisions about how to allocate the fund’s assets – doing what he or she is paid for, in other words. The next question, of course, will be whether those decisions prove right.

That brings us back to the issue of concentration. “Fundamentally, it’s down to the level of risk that you are willing to take,” argues Scott Gallacher, a director of financial adviser Rowley Turton. “A high conviction approach gives the fund manager, and therefore the investor, the chance of significantly outperforming the market; but it’s not a free lunch, and they could also significantly underperform.”

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Mix and match different fund approaches

Lipski urges to investors to think in the round, rather than focusing on a single fund. For example, if you do have investments in more concentrated funds, it may make sense to counterbalance these with more diversified funds. Equally, even if one fund isn’t particularly concentrated, you may have inadvertently introduced concentration by investing in other funds with similar holdings.

“You cannot control the risk that the fund manager takes but you can control risk and limit losses within your portfolio by being diversified,” Lipski says. “A good idea is to do an X-ray of your fund portfolio, where you look at its underlying stocks, to see where your main exposures lie. You may find that you have overlap between funds that makes your portfolio particularly bloated in one sector or company.”

One popular approach with some investors has been dubbed “barbell investment”. The idea here is that on one side of your barbell, you invest in lower-risk assets that provide something of a safety net; on the other side, you can then afford to make more speculative investments.

In a collective funds context, that would mean holding more diversified funds at one end of your portfolio – perhaps a selection of low-cost trackers. At the other, you could then focus on more high-conviction vehicles, safe in the knowledge that you’re getting diversification benefits elsewhere.

That does not mean the two sides of the barbell have to be equally weighted. The precise detail of your allocations will depend on your tolerance of risk. “There are many ways to think about structuring a fund portfolio and there’s no right and wrong,” adds Lipski. “The key is to have a plan that works for you, your time commitment, and your appetite for investment risk.”

Table one: Investment trusts with large single holdings

Source: AIC/Morningstar. Data according to most recent fund disclosures.

Table two: Highly concentrated open-ended funds

Source: Morningstar. Data according to most recent fund disclosures.