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Vito Maida is the president of Patient Capital Management Inc.

Highly diversified portfolios rarely outperform their benchmarks. However, a highly concentrated portfolio can add substantial value. If an investor can find a manager who can properly construct these concentrated portfolios, active management fees are justified. Otherwise, investing in low-cost index funds is a far better alternative for the long-term investor.

Most active mangers underperform their respective indexes over the long term. We recently undertook a study to determine the cause of this underperformance. We looked at different investment strategies. For example, some portfolios focus on growth stocks, others are based on value, and some are a collection of investments that the manager believes are the best available, irrespective of style, size or geographic location. Our assessment also took into account the fact that most portfolios hold anywhere between 50 and 100 stocks.

We tested three highly diversified strategies. First, we selected a random group of stocks from the S&P 500. We then divided the S&P 500 Index into its growth and value components and then generated arbitrary portfolios from these growth and value subindexes. For each of the three investment strategies we created hundreds of random portfolios holding 50, 75, and 100 equity investments.

For each of these portfolios we calculated the portfolio’s fundamental characteristics. We calculated their average price-to-earnings ratio, price-to-book-value ratio, dividend yield, return on equity and debt-to-equity ratio. We also calculated the same statistics for the S&P 500, S&P 500 growth, and S&P 500 value indexes.

The results of our numerous iterations all came to the same conclusion. Irrespective of the individual stock holdings, all the portfolio characteristics were very similar to their comparable index and to each other.

We then back-tested the performance of these portfolios against their relevant benchmarks. (The S&P 500 strategy was compared with the S&P 500 Index, the growth strategy was evaluated against the S&P 500 Growth Index and the value strategy was measured against the S&P 500 Value Index.) In virtually all cases, the performance of these portfolios was very similar to their corresponding index. But, after subtracting a management fee, they underperformed.

S&P 500 seen dipping between now and year-end: poll

It is very difficult to add value through diversification alone. As Berkshire Hathaway’s Charlie Munger says: “Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”

In contrast we used the same methodology to construct concentrated portfolios that only had 10 stocks. The results were quite different from the diversified portfolios that held many equity holdings. Our simulations showed that concentrated portfolios can vary materially in their characteristics and in their long-term performance from their benchmark indexes.

Indeed, a properly executed concentrated strategy can produce substantial outperformance relative to its benchmark. However, it’s important to note that these results potentially come with highly volatile returns and long periods of underperformance.

The chart below shows the annualized 15-year outperformance (before fees) of a sampling of 10 diversified portfolios relative to the S&P 500 Index and similar data for 10 concentrated value portfolios versus the S&P 500 Value Index.

In some cases, the value added of concentrated portfolios can be quite dramatic. The flip side is they can also produce very disappointing results. For example, one concentrated value portfolio produced an annualized return of 3.7 per cent over 15 years and lagged the 9.6 per cent annualized return of the S&P 500 Value Index over the same period.

To put the opportunities and risk of a concentrated portfolio in perspective, consider the following: $100 invested for 15 years in the S&P 500 Value Index returned approximately $396; invested in the best-performing concentrated value portfolio, $100 grew to about $880; and in the worst-performing concentrated value portfolio, the initial investment ended up at close to $172. (In some of the hundreds of cases tested, the randomly generated concentrated portfolios had negative returns over 15 years.)

In practice, the outcome depends on the skill of the portfolio manager making the investments. Implementing such a strategy is much harder than it appears. Each individual investment must be properly selected and just as importantly the manager must have the temperament and conviction to stay the course despite the higher volatility and the inevitable periods of underperformance.

The results of our study suggest that investors should not pay active management fees for managers who create highly diversified portfolios. These portfolios typically do not outperform their relevant benchmarks. A well-managed concentrated portfolio can add substantial value. If an investor can identify such a manager then active management fees are justified. Otherwise, investing in low-cost index funds is the way to go for long term investors.