We often hear that the number one rule of investing is diversify, diversify, diversify.

And on the face of it, so-called ‘concentrated funds’ – investment funds that typically hold no more than 50 stocks – would seem to fly in the face of this strategy.

Indeed modern portfolio theory, one of the first things professional investors learn before they enter the industry, dictates that more stocks in a portfolio the better, at least when it comes to combating volatility.

But managers of several of the most well-known funds out there, from houses like Lindsell Train and Fundsmith, typically run concentrated strategies across their funds.

According to AJ Bell’s head of active portfolios, Ryan Hughes, despite the perception of higher risk, concentrated funds can be a ‘good thing’.

He says, ‘They might look risky, but don’t look at these funds in isolation. In the context of an overall portfolio, concentrated funds aren’t a lot riskier and can perform well.’

ACTIVE SHARE

He cites a famous study from 2009 by academic researchers Martijn Cremers and Antti Petajisto regarding active share, i.e. the fraction of a fund’s holdings that deviate from the benchmark index it follows.

They found that high active share funds were more likely to ‘significantly outperform’ their benchmarks, both before and after expenses were deducted.

However, a later study by Vanguard found no relationship between high active share and strong investment performance.

Funds with a high active share typically deviate significantly from benchmarks like the FTSE 100 for example.

Concentrated funds tend to be pretty much only equity funds, as bonds funds have a lot more holdings.

WHY BOND FUNDS ARE DIFFERENT

Bond fund managers are known in the investment world to be a pessimistic bunch, and having more bonds in their portfolios helps them manage risk better.

Hughes explains: ‘The downside risk in bonds is high i.e. a bond fund has limited upside given all you get is your coupon plus a return of capital but can lose a lot of money if the manager gets it wrong so they mitigate this by holdings lots of different bonds.’

Of course there is another school of thought on concentrated funds, which argues that adding more stocks dilutes your best ideas.

Veteran buy-and-hold investor Richard Oldfield goes to greater lengths; he believes all you need is around 15 to 20 stocks and then you’re diversified. After that, he argues that gains in diversification are marginal. The average number of holdings for UK funds is somwhere around the 50 to 60 mark.

A great recent example of the potential pitfalls of concentrated funds is revealed by Lindsell Train fund manager Nick Train’s comments in September 2019 about educational publisher Pearson (PSON).

Train is a longstanding backer of the stock, and continues to stick with it, but recently confessed he is ‘mortified’ after another profit warning from Pearson, something which he said has become ‘traditional’ for the company.

In his latest update Train said, ‘At its month end close of £7.38 there has not been a ruinous loss of value for fund holders, although there is an unrealised loss on our book cost, but there has been an opportunity cost hanging on to this holding, when other ideas we have had, have done so much better.’

As a result Lindsell Train UK Equity (B18B9X76), which holds just 24 stocks including Pearson, returned -0.3% in September, compared to a 3% return for its benchmark.

Of course there is always risk in investing, and not all stocks or funds will work out all of the time.

CONCENTRATED FUNDS HAVE A PLACE

But for the average investor, concentrated funds have their place in a portfolio.

To start with, it is probably sensible to own between five and 10 funds which are global and diversified, but for the more experienced investor, then 15 to 20 funds of a concentrated nature would be a reasonable amount for a portfolio.

Below are two suggestions from AJ Bell’s favourite funds list.

TB Evenlode Income (BD0B7D5)

A UK equity income fund, TB Evenlode Income (BD0B7D5) tries to outperform the FTSE All Share index by investing mainly in large cap names with an emphasis on income.

And over a one, three and five year basis, the fund has done exactly that.

On an annualised basis, its trailing returns have been 14.7%, 11.97% and 13.27% over one, three and five years respectively, well ahead of the 2.68%, 6.76% and 6.79% returns respectively from the FTSE All Share.

Holding just 38 stocks, manager Hugh Yarrow – another highly regarded manager in investment circles – seeks to pick companies with high profitability, low capital intensity and low debt levels.

The fund pays a dividend quarterly, with its 3% yield broadly in line with other funds in the sector.

Stewart Investors Asia Pacific Leaders (3387476)

If concentrated funds generally sound risky, and if investing in emerging markets like the Asia Pacific region also typically appear risky, then this fund probably might seem super risky.

There is merit to this argument, and there is always risk in investing of course, but Stewart Investors Asia Pacific Leaders (3387476) has proven itself to be as conservative as it gets in this area

Investing in anywhere between 30 and 60 large cap stocks (it currently holds 35), the fund’s managers look for high quality companies whose share prices might be a little undervalued but who can still offer sustainable earnings growth.

The fund has beaten its benchmark more years than not but doesn’t necessarily come out on top in terms of overall performance.

Where it shines however is in its standard deviation, a measure of risk which determines how much an asset’s performance varies over time.

The fund consistently ranks higher than virtually of its peers when it comes to this measure of risk, with a lower standard deviation than most. That’s probably why it holds £7bn of investors’ money.

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