What is the perfect number of companies that an investment fund should hold within its portfolio to make your money grow? No one knows.
Ask a dozen clever fund managers and you’re likely to get a dozen different answers. Some invest in just a handful of companies, others in several hundred.
And while there is variety in the number of companies they hold, there is one matter on which fund managers are consistent: they all believe their approach is the best.
Recipe for success: We rely on fund managers to come up with the best strategies to grow our wealth
This doesn’t make life particularly easy for ordinary investors. We rely on fund managers to come up with the best strategies to grow our wealth, but how can we trust their approaches when they vary so wildly?
Of course, the number of company holdings is just one of the characteristics of a fund, and its investment success relies on other factors. But it reveals a great deal about the fund manager’s strategy and their chance of making a good return.
That’s why Wealth has crunched the numbers and spoken to fund managers from both camps: those who like to run concentrated portfolios and those who prefer to spread their investments across as many companies as possible.
Good things come in small packages
Undoubtedly, many of the best-performing investment funds hold just a small number of companies.
In the table below, wealth platform AJ Bell has calculated the ten-year returns generated by those funds – invested either in the UK stock market or globally – with the smallest number of company holdings.
For example, fund house Lindsell Train has UK and Global funds (UK Equity and Global Equity) that have turned a £1,000 investment into an impressive £3,421 and £4,590 respectively over ten years, outperforming their respective benchmarks. It has done this by investing each fund in fewer than 30 companies.
Similarly, Fundsmith Equity, run by star manager Terry Smith, holds just 29 companies from across the world. It has turned every £1,000 investment into £4,692 over ten years.
Both Lindsell Train and Fundsmith believe a concentrated portfolio is key to their investment success. Only in this way can they keep a close eye on the companies in which they invest. As Fundsmith tells clients: ‘Most fund managers own too many stocks. How much can you know about the 80th company in your portfolio?’
Many fund managers also believe that a sprawling portfolio runs the risk of looking too similar to the index it is trying to outperform.
As a result, it stands little chance of beating it. An index simply tracks the performance of an overall stock market and is made up of hundreds or, in some cases, thousands of companies.
For example, it will track the biggest companies listed in the UK (the FTSE100) or even the largest companies listed around the world (MSCI World).
A fund manager carefully handpicks those companies they believe will do better than the index over the long term. However, if they pick too many companies, it becomes harder to differentiate their fund from the index and therefore more difficult to outperform it.
Matthew Page is manager of fund Guinness Global Innovators which has turned £1,000 into £5,521 over ten years. There are just 31 companies in the portfolio, which puts it among the ten most concentrated global funds.
Page says: ‘As an actively managed fund, we try to find best of breed companies which we can build a portfolio around that is going to be different from the benchmark.
‘We don’t want to have too few companies because the impact on the portfolio is too high if something goes wrong with one company.
‘But in our fund, each holding makes up around three per cent of the portfolio, which controls overall risk but also allows us to build something unique.’
…Or perhaps big is beautiful?
As the table shows, there are some investment funds with hundreds of holdings that still manage to shoot the performance lights out.
Take Marlborough Special Situations, for example. This fund currently comprises 155 companies, but over the past 20 years it has sometimes held 220 stocks.
It is among the most diversified UK funds, although some rivals have even more holdings. It has turned £1,000 into £4,242 over ten years – better than some concentrated UK funds.
Marlborough’s managers believe they have found the secret to holding a diverse portfolio: a big investment team who are willing to speak their minds.
Co-manager Eustace Santa Barbara says: ‘The legendary investor Warren Buffett once reportedly said, ‘Keep all your eggs in one basket, but watch that basket closely.’ We have lots of eggs, but lots of eyes watching our basket. There are about a dozen of us, with a huge amount of experience.’ Santa Barbara believes that a large basket of shares is essential due to the type of fund he co-manages. Marlborough Special Situations invests in small UK companies, which tend to be unproven and therefore riskier than large, established companies.
He says: ‘We would like to get it right every time when it comes to picking stocks, but with the best will in the world, we just don’t.
‘That is why we think it is safer to have small stakes in lots of really exciting opportunities. Then, as we become more comfortable with a company, we start to increase our holding. Conversely, if we lose confidence in a holding, we quickly drop it.’
Then there’s the ‘Big and active’ approach
The higher the number of holdings in an actively managed fund, the closer it is likely to resemble its benchmark. But that is not always the case.
Pictet Global Megatrend Selection is an active, global fund made up of 550 stocks. However, despite the large number of holdings, there is very little overlap with its index, the MSCI World Index of over 1,500 global companies. That is because Pictet Global Megatrend Selection is constructed from stocks held by 12 different Pictet thematic funds, each overseen by its own management team.
Senior product specialist Marc-Olivier Buffle explains: ‘Each thematic fund is run by three or four managers and typically holds 40 or 50 stocks.
‘The Pictet Global Megatrend Selection aggregates the ideas from all these teams into one fund. As a result it’s a highly-actively managed fund that looks very different from the index. In fact, 45 per cent of the stocks in the fund are not in the MSCI World at all.’
…or let the algorithms design a portfolio
Many of the active funds with the biggest number of holdings use algorithms rather than just relying on fund manager expertise to compile a portfolio.
In a technique known as factor investing, fund managers will apply filters to an index to give extra weighting to companies displaying the characteristics they believe stand them in good stead to outperform the market.
Invesco Global ex UK Enhanced Index Fund, for example, invests in around 400 of the 1,583 companies that form part of the MSCI World ex UK index.
It has turned a £1,000 investment into £3,689 over ten years, slightly underperforming the index.
Senior portfolio manager Georg Elsäesser explains that they filter the index to favour companies they believe are cheaper, better quality and have stronger growth momentum than rivals.
He says: ‘Using this process, we aim to produce a long-term excess return above the index.
‘However, because we are limited as to how much we diverge from the benchmark, our returns will never shoot the lights out.’
So what should ordinary investors do?
Emma Wall is head of investment analysis and research at wealth platform Hargreaves Lansdown.
She believes that in general, the smaller the companies a fund invests in, the more diverse the underlying portfolio should be.
‘As a rule of thumb, the bigger the stocks that a fund manager is investing in, the more concentrated a fund portfolio they can get away with holding,’ says Wall. ‘That is because bigger companies are more established and therefore usually less volatile to invest in.’
In contrast, she says, if you’re holding smaller companies, these tend to be riskier and so a diversified fund portfolio is preferable.
‘You don’t want to double down on the underlying risk by buying a concentrated portfolio which adds its own risk,’ Wall adds.
Investors may also be able to learn from this approach in their own investment decisions.
Laith Khalaf is head of investment analysis at AJ Bell. He believes that ordinary investors should limit the number of actively managed funds they hold to increase the likelihood of outperforming the market.
However, this needs to be balanced by holding enough active funds to not be too exposed if one does badly.
Khalaf says: ‘A high conviction approach to investing is generally preferable. If you can identify skilful investment managers, this gives you a better chance of outperforming the market. But this does add risk because one bad apple can spoil the cart.’
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