Unlocking the Power of Stock Ideas: Less is More
Do you ever wonder how many stock ideas a professional fund manager like Naomi has at any given time? Surprisingly, it’s between 10 and 20, according to her. So, why then do funds end up holding a much larger number of stocks in their portfolios?
The answer lies in the need to diversify the portfolio, as Naomi explained. But is this strategy really the best approach? The reality is that many fund managers dilute the potential returns of their best ideas by including too many mediocre ones in their portfolio.
Are Professional Managers Skilled Stock Pickers?
While the consensus may lean towards a negative answer, studies have shown that professional managers can indeed be superior stock pickers if they stick to their top 10 to 20 best ideas. The key lies in focusing on quality over quantity.
Research by Miguel Anton, Randolph B. Cohen, and Christopher Polk highlights that the top stocks held by active equity mutual funds often outperform the benchmarks significantly. However, this performance diminishes as the number of stocks in the portfolio increases beyond the top 20.
Collective Stock-Picking Skill
At AthenaInvest, we rate stocks based on the fraction held by the best active equity funds, identifying the best and worst idea stocks based on this collective skill. The data shows that the best idea stocks consistently outperform their benchmarks, while bad idea stocks underperform.
By focusing on a concentrated portfolio of the best ideas, fund managers can potentially exceed their benchmarks and avoid becoming closet indexers.
Investing in Bad Ideas
Portfolio volatility and emotional triggers often drive the inclusion of bad ideas in funds. However, studies suggest that a focused portfolio of high-conviction stocks can outperform a broadly diversified one in the long run.
Emotional reactions to short-term losses and the desire to minimize tracking error can lead funds astray, causing them to sacrifice long-term returns for short-term stability.
Avoiding Bad Ideas
To steer clear of underperforming funds, investors should consider the following strategies:
- Invest in specialist funds with a narrow strategy
- Look for funds with a long track record of consistent performance
- Diversify across best idea funds with different strategies
- Choose high-conviction funds with fewer stocks and lower assets under management (AUM)
- Opt for funds with an R-Squared range of 0.60 to 0.80
Turning the Tide on Closet Indexing
It’s time to change the narrative in the investment industry and move away from closet indexing. By focusing on quality over quantity and avoiding bad idea funds, investors can potentially enhance their long-term wealth accumulation.
Remember, the key to success in the market lies in unlocking the power of your best ideas and staying true to your investment convictions.
If you found this post insightful, be sure to subscribe to Enterprising Investor and the CFA Institute Research and Policy Center for more industry insights and updates.
Disclaimer: The opinions expressed in this post are solely those of the author and do not constitute investment advice. Views expressed do not necessarily reflect the opinions of CFA Institute or the author’s employer.
Professional Learning for CFA Institute Members
CFA Institute members can earn professional learning (PL) credits by engaging with content like this. Keep track of your credits using the online PL tracker available for members.