Tadas Viskanta of Abnormal Returns has written an interesting piece entitled 5 reasons to ignore top 10 stock lists. As the title suggests, in it he argues against the common investment media meme to publish (typically at year-end) “Top 10” lists of supposedly great stocks.
Tadas begins by noting the folly of forecasting, a point with which I agree and have written about often (for example, here, here and here). He also makes the sensible point that such lists ignore risk. I’d add that such lists can be deceptive for individual investors because no investment — no matter how “good” — ought to be utilized unless and until it is consistent with one’s overall plan, goals and risk tolerances. His reference to the “time frame mismatch” is also a good one. Circumstances change and sometimes such changes demand response.
The other two reasons Tadas provides are more problematic. He argues that “In today’s market ten securities is likely not enough to compose a diversified portfolio. It definitely doesn’t hold if you plan to have a globally diversified portfolio.”
But if you want your portfolio to outperform, why would you want it to be “globally diversified”? Otherwise, buy index funds.
Unfortunately, most “actively managed” funds are highly diversified. As a consequence, they cannot be expected to outperform. The more stocks a portfolio holds, the more closely it resembles an index. The average number of stocks held in actively managed funds is up roughly 100% since 1980, according to data from the Center for Research in Security Prices. See Pollet & Wilson, “How Does Size Affect Mutual Fund Behavior?” Journal of Finance, Vol. LXIII, No. 6, p. 2948 (December 2008). Large numbers of positions coupled with average turnover in excess of 100% (per William Harding of Morningstar) effectively undermines the idea that such funds could be anything but a “closest index.” Such excessive diversification is merely (in Warren Buffett’s words), “protection against ignorance.” It makes no sense to incur excess costs and to suffer tax inefficiencies to purchase an investment that, in effect, is a closet index.
On the other hand, a variety of studies show that funds which are truly actively managed, and which are thus more concentrated (among other things), outperform indices and do so with persistence. See, e.g., Brands, Brown & Gallagher, “Portfolio Concentration and Investment Manager Performance” (2005); Cremers & Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” (2007). As summarized by Cremers and Petajisto:
“Funds with the highest Active Share [most active management] outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses …. The best performers are concentrated stock pickers ….We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum. From an investor’s point of view, funds with the highest Active Share, smallest assets, and best one-year performance seem very attractive, outperforming their benchmarks by 6.5% per year net of fees and expenses.”
To be clear, at least some diversification is always appropriate to manage risk. An individual investor may appropriately diversify among managers, styles and strategies. But diversification within each of those categories is necessarily counterproductive. An active manager can only outperform via market timing and/or security selection. Broad and deep diversification undercuts the possibility of outperforming via security selection.
Tadas then goes on to argue that “Top 10” lists inflate the value of security selection. Here’s his case:
“If nothing else the past few years have taught us the fact that security selection can take a back seat to larger economic/macro influences. The far bigger and more important decisions investors have to make have to do with risk tolerances, asset allocation, etc. Security selection is at best the last item on a financial plan.”
The planning aspect of the argument is spot-on. An excellent financial plan should always begin with a careful review and understanding of goals, needs and risk tolerances and the creation of an appropriate asset allocation plan. I also readily acknowledge that “security selection can take a back seat to larger economic/macro influences.” Those influences relate directly to the other potential source of outperformance for the active manager — market timing. Sadly, however, the evidence (with the exception of very disciplined trend followers and momentum traders) that one can beat the market via market timing is more problematic than that for security selection. As Tadas argued initially, forecasting the future is really hard. That said, the proposition needn’t be either/or with respect to global macro and stock picking. Why not both/and?