Can Concentrated Portfolios Compete with ETFs?

As low-cost indexing strategies – usually in the form of ETFs – have increased in popularity, we’ve frequently opined that one of the major changes for the investment industry will be the shrinking of investment funds that are providing “high-cost” beta. We would define high-cost beta as an investment fund that charges management fees over 1 percent and provides returns that are extremely similar to the index the fund is meant to track.

These managers may be “active” in the sense that they are making fundamental investment decisions on which stocks to overweight or underweight in their investment universe, but if their active bets aren’t material enough to provide returns that are substantially different than the index, then why as an investor would you pay high fees when you can buy an ETF that tracks the S&P 500 for 0.04% percent? This article from the Wall Street Journal illustrates that in an effort for investment managers to differentiate themselves from low-cost indexing strategies, the number of funds that take concentrated bets is growing. The rationale is that in a more concentrated portfolio, a manager can focus on their best ideas and as a result should provide a return stream that is substantially different from an index, while hopefully delivering alpha. The interesting part of this article is that while concentrated bets lead managers to have more “active risk,” there is no guarantee these concentrated bets will lead to outperformance. Theoretically, with active risk, the potential for either underperformance or outperformance should be equally distributed.

The fundamental law of active management states that the success of a trading strategy is proportional to the manager’s skill multiplied by the number of independent bets made (breadth). Therefore, while the strategy of investment managers constructing concentrated portfolios as a way to differentiate themselves from an index might result in a few managers achieving the success of famous managers (e.g., Soros or Paulson), on aggregate the cohort is likely to continue to underperform given the number of active bets as a whole remains small.