Almost half a century ago, Lawrence Fisher and James Lorie from the University of Chicago published a research piece
in the Journal of Business on how portfolio diversification reduces overall risk in a portfolio.
One of their key findings was that with a portfolio of 32 randomly picked stocks they could reduce the overall volatility level, or risk level, of their portfolios to almost the same volatility levels as the broad market.
The concentration level of the portfolios we currently manage partially derives from these findings. As a high conviction manager, my objective is to run a concentrated portfolio in which every single investment case brings a real contribution to the portfolio’s overall performance while keeping the overall risk level under control through an appropriate level of diversification.
In line with this strategy, our Flagship UCITS Fund holds between 30 and 40 individual positions
which is pretty much in line with the 32 positions suggested by Fisher & Lorie in the above mentioned research. Based on our investment approach, holding less stocks would induce some challenges to respect at all times UCITS diversification constraints
(i.e. “5-10-40” rule) while increasing the number of positions above 40 names would not reduce substantially further the overall risk of the portfolio.
Since I joined European Capital Partners, I’ve met plenty of (potential) investors to present them our “Entrepreneurial Value” Investment philosophy. During the Summer 2015, when meeting with a family office, the topic of portfolio concentration was raised and, if the resonance on our investment philosophy was positive, their opinion was that by running a portfolio of 30 to 40 individual names, we were diversifying away our value add as stock pickers.
While we understand that a family office views the individual asset manager in the context of his overall portfolio and may not want to own 10 managers with 40 names each, we were somewhat disappointed to be “accused” of hiding behind diversification.
This lively and interesting discussion led me to a deeper reflection and prompted us, in order to meet this specific demand for more concentrated portfolios, to develop a paper portfolio investing in only 10 individual stocks.
This model portfolio was established more than two years ago and, as shown in the table below, interesting conclusions can be drawn from a comparison between this portfolio, the market and our UCITS strategy.
Source: ECP, Bloomberg, gross return data as at 23/03/2018. NB: 10 stock portfolio is a paper portfolio. Past performances are no indication of future returns.
In a nutshell, we are satisfied with the risk/return profile of our UCITS portfolio but are also aware that, for certain type of investors, an even more concentrated portfolio could make sense without much more risk taking. Unfortunately, such a strategy can however not be launched as a UCITS vehicle but only as an AIF or a managed account.
So, Avis aux amateurs !
- Over 2 years, with less than 40 individual positions, our UCITS strategy does exhibit a lower risk profile than the market (represented by the MSCI Europe). Thus, it has been able to outperform at a lower risk, which results in a more attractive Sharpe ratio than the market. This finding seems to confirm the conclusions drawn by Fisher & Lorie in their academic study. The difference being that we do not charge management fees to randomly select companies but select them through very strict investment criteria.
- More surprisingly, over the same period of 2 years, our high conviction portfolio, which we call internally "the essence of stock selection", does not present, with only 10 individual positions, a substantially higher level of risk than the market while the performance speaks for itself. Unfortunately for us, this is only a model portfolio!