Less is more: how concentrated funds can navigate market volatility?

Asset allocators are increasingly blending concentrated active strategies to achieve greater alpha within portfolios –but can focused portfolios also help cushion capital losses? Concentrated portfolios not only deliver outperformance but also help to navigate volatility over the long term.

From an academic point of view, fund managers need 20 stocks to sufficiently diversify the majority of risk. Beyond that, marginal contribution to risk reduction falls sharply. However, over the long-term, I believe concentrated portfolios can better mitigate capital losses by exploiting bouts of volatility.

We know concentration, by itself, is not a way to protect returns in the short term. The opportunity to navigate fluctuating markets lies, instead, in the very volatility that causes violent market swings. It is at the height of market fear when truly active contrarian investors can exploit indiscriminate selling to find value among quality stocks. Hence, the advantage of concentrated portfolios lies in the long term: when the market finally catches up with bottom-up fundamental analysis.

Identifying competitive advantage

The dominant organisational model in the world is centred on specialisation. People are more efficient when focusing on one task over many – think of the individual positional expertise in a football team. The same is true in investment: focusing on fewer companies not only allows you to understand companies, but also affords you the time to conduct forensic research into risk mitigation.

Concentration also allows you to focus on certain types of business models which can protect on the downside. For example, we focus on buying companies that have strong competitive advantages, i.e., something unique within a business model that can deliver strong returns through the economic cycle. We then combine robust balance sheets that will help harbour these stocks from macroeconomic headwinds.

We can further protect the portfolio by accessing these stocks at attractive valuations. These are times when stocks are out of favour with shorter-term investors. As these points of entry tend to be rare (and we have strict selection criteria) it means patience is paramount to our process.

Diversification is not necessarily your friend

It is also important to stress-test the portfolio in different market conditions. Merely holding a basket of sectors will not necessarily provide diversification – in fact, it can leave you with a false impression of how well your assets are spread. This is because over-riding macroeconomic or sentiment-driven reasons can cause multiple sectors to fall out-of-favour.

It is also important to note that one equity strategy is unlikely to give you optimum exposure within a well-diversified portfolio. The task of an asset manager should also be helping clients understand structural biases to allow them blend funds with other managers and strategies to achieve the sector allocation they desire.

The volatility of investment markets can test the mettle of any investor. The key is to stay true to your conviction and remain steadfastly contrarian. But above all, be patient and don’t comprise your process.

As Aristotle once remarked, “patience may be bitter, but its fruit is sweet.’

Michael Clements – Head of European Equities – SYZ Asset Management