Diversification: How much is too much?
Relative performance is important. But fund size and conviction in ideas also dictate the number of stocks
How much is too much? This is the diversification question that often comes up. Portfolio theory states 25-30 stocks are needed for efficient diversification and the best risk-return trade off. On the other hand, veteran long-term investor, Warren Buffett says that diversification is for those who don’t know what they are doing (investing in).
If you consider domestic equity diversified funds, there are some with 70 stocks and others with 20. So then which strategy works better?
To answer this question, Mint Money analysed the performance of top 10 funds (by assets under management, or AUM) that consistently held more than 50 stocks every month (as seen in month-end portfolios) against that of top 10 funds (AUM) which consistently held lesser than 35 stocks every month. What we found is that there were at least three funds in the less than 35 group that have underperformed their benchmarks in a 3-5-year period and none of the funds in the 50-plus stocks group underperformed the benchmark on long-term returns.
Is this enough to conclude that open-ended diversified equity funds need to lean towards over-diversification? This analysis alone is not convincing. All three funds that underperformed have different strategies and fit into different categories. Hence, other factors could be at play and concentrated portfolios may not be the primary driver. Nevertheless, it is worth dwelling on what fund managers think about portfolio size, conviction picks and diversification.
Why diversify?
Investing in stocks or any financial securities is as much about returns as it is about risk. Where the risk of losing capital is high, one looks to diversify by investing in more than just one security. In case of securities like bonds, this risk is more pronounced due to a probability of default and lack of stock market-like liquidity. For equity funds, recovery of capital is more a function of market environment.
That’s why the return trajectory of a stock is difficult to anticipate beforehand. Fund managers invest in companies where they find there is visibility of future earnings growth and the stock is available at a price they are willing to pay.
However, the actual change in price of a stock is a function of various factors like demand-supply, corporate actions and market dynamics, among other things.
Thus arises the need to diversify, to safeguard investors’ capital as much as possible.
“Any equity fund needs to be adequately diversified. Concentration of holding within few stocks carries the risk of price correction as well as time correction; both are equally damaging. It also restricts a fund manager’s ability to change the positioning even when the view on that stock undergoes a change,” said Ritesh Jain, chief investment officer, Tata Asset Management Ltd.
How many is too many?
Is a 30-stock portfolio enough diversification or do we need more?
Manish Gunwani, senior fund manager equity, ICICI Prudential Asset Management Co. Ltd, said, “The number of stocks is an outcome of the strategy rather than a starting point. In 2008, when we launched our Focused Bluechip Equity Fund, the strategy was to build a concentrated portfolio of 20 high conviction stocks. The concentration risk was mitigated by following a benchmark hugging strategy. As the size increased (9,681.43 crore as on 31 October 2015), we have also increased the number of stocks to 45.”
Existence of a benchmark forms the basis of portfolio building for open-ended equity funds. At a root level, this can somewhat define the level of diversification as open-ended equity funds strive for relative returns rather than absolute performance. To get an exposure to 10-12 different sectors (which a benchmark might have) at least 30-35 stocks will be needed.
At a minimum, most equity diversified funds will have at least 20 stocks, beyond that additions are a result of getting adequate exposure to relevant sectors, market dynamics, market capitalisation orientation of a fund and so on.
There are funds with a very focused strategy that don’t hold more than 20-30 stocks. In such cases, it’s either about the fund structure (strategies where the funds are restricted by mandate to specific number of stocks) or the fund managers’ strategy to maintain a portfolio with high conviction While, relative performance and liquidity are important in carving a diversification strategy, fund size and conviction in ideas also dictates the number of stocks.
Barring any specific mandate, if a fund manager is sure of the market direction and large-caps are reasonably priced, then a portfolio can be more concentrated.
There is no given number that works but many experts agree that beyond 40-50 stocks contribution to incremental returns isn’t meaningful. Rather it’s the concentration of the top holdings and the quality of diversification that is more influential for performance.
Large- versus mid-cap funds
The level of diversification differs when we look at large- versus mid-cap funds.
Large-cap stocks are more liquid, which means it is easier to enter and exit these stocks without impacting the price on any given day. The operative issue in mid-caps is the lack of liquidity.
“Diversification assumes much more importance for mid-cap funds. Liquidity is much lower, and by nature, these stocks can have extreme reactions to news flows and corporate developments, leading to volatile stock prices as compared to large caps,” said Jain. Hence, many fund managers diversify to a higher degree in mid-cap funds leading to more stocks in the portfolio.
It helps that the overall market capitalisation of large-cap stocks is higher (in context to domestic equity market); it is easier to buy just one or two stocks within a sector or theme.
“In a large-cap fund, given that stocks are liquid and well established, one can get reasonable sector exposure with a fewer companies. In mid- and small-cap funds, the number of stocks can be higher as sometimes you can’t buy just one stock for the total value of exposure you want and then you might buy 3-4 stocks with similar characteristics,” said Sunil Singhania, chief investment officer-equity investment, Reliance Capital Asset Management Co. Ltd.
For many mid-cap companies the market cap isn’t high. For example, a 100-crore investment in a mid-cap company with a 2,000-crore market cap amounts to 5% ownership in the company.
A long-term equity fund manager, who did not want to be named, pointed out that there are many large-cap companies with market cap higher than the total assets of a large-cap fund. Whereas, the number of quality mid-cap companies with a market cap higher than a mid-cap fund’s size is lower.
In addition to this, lack of liquidity in mid-caps can also make entry and exit a gradual process, which can lead to a tail of ‘in-transit’ stocks. But too many small positions aren’t useful to keep. “If you own less than 1% in one stock, there is no meaningful impact for the fund. It is in the fund manager’s interest to ensure that there aren’t too many marginal positions,” said Singhania.
Stocks left at the bottom might just be a result of the need for liquidity, idle management or an inability to conclude a position (add or reduce a particular stock) immediately.
Mint Money take
Over- or under-diversification assumes importance when long-term performance gets impacted. Concentrated portfolios are more common when it comes to portfolio management schemes (PMS). These have a limited high net worth investor base. There is a lot more in-depth investor interaction. And fund sizes don’t usually expand (or reduce) too much too soon. Hence, a fund manager can take advantage of concentrated portfolios to deliver potentially higher returns (though success depends on each individual manager’s ability).
Different schools of thought coexist; there are managers who won’t take the number of stocks beyond 25-30 and others who are comfortable managing 60 stocks in a portfolio.
The question is: can you get an even higher return by restricting the number of stocks? Possibly, yes, but then a manager must be able to manage the risk; performance volatility and liquidity-related risk.
So far there is no conclusive evidence that long-term performance is impacted meaningfully on the basis of number of stocks. You should pick your mutual fund scheme for its strategy and conviction in running that strategy which is more important than just looking at the level of diversification.
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First Published:29 Nov 2015, 10:31 PM IST
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