The pros and cons of portfolios with only a small number of holdings have come under the spotlight after ratings company Morningstar downgraded LF Lindsell Train UK Equity (B18B9X7) from Gold to Bronze. Among the reasons cited was the higher levels of stock-specific risk than most peers created by the fund’s portfolio being concentrated on just 23 stocks.

The counterpoint to Morningstar’s concerns, and one made by Lindsell Train itself (and acknowledged by Morningstar), is that the concentration has made a big contribution to an enviable long-term track record.

To be classified as a concentrated portfolio you would generally need less than 50 holdings. Adopting this approach means taking relatively big bets on assets in the portfolio. If the investor gets it right then they could see market-beating gains – but get it wrong and the results could be disastrous in relative terms.

TRENDS WITH CONCENTRATED PORTFOLIOS

Aberdeen Standard Investments was recently appointed to take over running LF Woodford Income Focus (BD9X6D5) and it will adopt a high conviction approach, targeting around 30 positions.

New investment trust Nippon Active Value Fund plans to float on the UK stock market in February with a very concentrated portfolio, targeting up to 20 small to mid-cap Japanese companies. In this case the concentrated approach is linked to its aim of being an activist investor.

Rising Sun Management will run the fund and chief investment officer James Rosenwald says: ‘The directors of Rising Sun Management have developed a focused approach to activist investing, which we will utilise in Nippon Active Value Fund.

‘For example, we have generated reasonable returns for clients using highly concentrated positions by taking board seats and making shareholder proposals at annual meetings.’

By investing in fewer holdings funds are also more exposed when something goes wrong with an individual investment. The reverse is true too, a good call will have a more appreciable impact on performance. The net result is these funds are likely to diverge more from the wider market and their benchmark.

BEATING THE BENCHMARK

There are arguments in favour of a more conviction-based approach. Active managers get paid to make investment decisions and a highly diversified fund which hugs its benchmark could struggle to justify the extra cost compared with a passive tracker fund.

LF Blue Whale Growth Fund (BD6PG78) has just over 20 holdings and launched in September 2017. Over the last 12 months the fund has achieved a cumulative performance of 26.2% against 19.8% for the IA Global benchmark.

Co-manager Stephen Yiu says: ‘We felt there was a shortage of funds in the market which aim to deliver significant outperformance and if you want to have a product which offers potential for significant outperformance you need to run a highly concentrated portfolio.’

ARE CONCENTRATED PORTFOLIOS COMMON?

Shares has identified 28 open-ended funds with holdings of 25 or less and which have three-year performance track records. Out of this number, 18 have outperformed their relevant benchmark according to FE Fundinfo.

One fund in this category which has not performed that well is MI Downing UK Micro-Cap Growth (B2403R7). Steered by Judith MacKenzie since its inception in 2011, holdings in the likes of home safety products firm FireAngel Safety Technology (FA.:AIM), professional services outfit Norman Broadbent (NBB:AIM) and delivery group DX (DX.:AIM) have not paid off in recent times. Over the last three years the fund is down 16% against a 39% advance from the IA UK Smaller Companies benchmark.

Arguably this fund’s approach leaves it exposed to two significant risks, both the greater volatility inherent in smaller company shares, alongside the lack of diversification.

MANAGING THE RISKS

So how do managers look to mitigate the risks associated with running a more concentrated portfolio?

There is an emphasis on really doing the homework on a stock and as Blue Whale’s Stephen Yiu says this is easier with a more limited number of shares.

‘My understanding is a large number of fund managers do not have a lot of resources. If you have two people running 75 stocks and working 10 hours a day, that leaves just five hours  per stock.

‘We have a team of five, and working the same 10 hours a day we can spend a much greater amount of time looking at individual stocks.’

Yiu points out that unlike some funds he and his team do not rely on broker research which is available to competitors, allowing them to come up with more original investment ideas in-house.

POINTS TO CONSIDER

Provided you do your own research diligently there is no inherent reason to avoid buying a fund with a small number of holdings, but crucially only as part of a diversified portfolio.

This way if a previously lauded fund manager loses their golden touch or faces a series of unexpected failures among their investments, the impact on your personal wealth will be contained.

Yiu adds that to achieve diversification it might be preferable to invest in three different high conviction funds with limited crossover in terms of their holdings, thus benefiting from the expertise of three separate fund management teams, rather than buying a single more diversified fund.

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