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1 July 2016 Financial Analysts Journal

Better by Design (Summary)

  1. Phil Davis

This In Practice piece gives a practitioner’s perspective on the article “The Effect of Management Design on the Portfolio Concentration and Performance of Mutual Funds” by Eitan Goldman, Zhenzhen Sun, and Xiyu (Thomas) Zhou, published in the July/August 2016 issue of the Financial Analysts Journal.

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What’s the Investment Issue?

Investors and regulators are sceptical about active management. This attitude is not surprising given that, in aggregate, active portfolios underperform their benchmarks. However, active management is not moribund: A great many investors believe in the ability of actively managed funds to outperform. The question is how and why do some funds outperform? The answer to this question is important in helping to foster trust in the investment industry and in individual firms and managers.

The authors focus on mutual funds with concentrated portfolios, mainly because there is existing evidence that concentration leads to outperformance but also because there is incomplete evidence about why this is the case.

This study goes farther than previous studies into the return benefits of portfolio concentration by examining not only cross-sector concentration but also within-sector concentration. It also looks beyond portfolio composition to the fund managers themselves—specifically, at the number of managers running a fund—to see whether different fund management designs and personnel structures affect performance.

What Are the Findings?

This study produced three key findings with potentially powerful implications for investors and the fund management industry.

Perhaps the most significant finding is that mutual funds run by a single manager tend to have a much higher portfolio concentration, both across and within industries, than funds run by multiple managers. The authors found that when funds’ management designs are changed from a single manager to multiple managers, portfolio concentration decreases and performance deteriorates. The more managers funds have, the worse their performance compared with funds run by single managers. The authors observed that, on average, funds with a single manager outperform funds with two managers by 0.41% a year, rising to 1.30% when funds have more than two managers at the helm.

The second finding is that concentrated stock picking within industries enhances returns compared with concentrated stock picking across the industry spectrum. This finding suggests that concentrated portfolios do not outperform simply because they fortuitously allocate to industries with strong upward momentum. It is evidence, say the authors, that manager skill actually does enhance returns.

A third finding is that older funds and funds with longer-serving managers tend to perform worse than the average fund.

What Are the Implications for Investors?

There are three key takeaways from these findings for mutual fund investors, of which fund managers will wish to be cognisant.

First, investors may be better off selecting funds with portfolios concentrated in the top one or two stocks within each industry.

Second, investors might contemplate divesting from funds that switch from using a single manager to using multiple managers. In contrast, if a fund switches from using multiple managers to using a single manager, the change may represent an investment opportunity.

Finally, investors might also consider redeeming older funds run by long-serving managers.

The authors point out that these are not blanket recommendations but, rather, may become considerations for investors when selecting funds.

What Are the Implications for Investment Firms and Managers?

This study turns conventional wisdom on its head.

First, conventional wisdom says that two heads are better than one. This is certainly the belief of most investment firms, where funds tend to be based on teamwork and multiple-manager structures predominate. This study shows, to the contrary, that single managers outperform multiple managers. In other words, the much-demonised “star culture” should actually be burnished, not banished.

Second, the authors challenge the notion that diversification within a fund adds value. Their research suggests that a fund that invests in a reduced number of stocks and, ideally, a reduced number of industries, has a greater likelihood of outperformance.

Finally, this study undermines the concept that experienced heads know best. It suggests that the notion that established funds and long-serving fund managers outperform is not true. This finding could lead to some (difficult) personnel discussions within some firms.

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