I met a colleague recently who told me that he invests in global equities but wasn’t sure how to choose a strategy amongst hundreds of options. He asked me:
“What would be the one thing I should look at when trying to select a strategy?”
Put on the spot, my mind ran through the possibilities: what about the usual trinity of ‘people, philosophy and process’? Too many and too qualitative. ESG? Too complicated. Performance? Too blunt.
In the end, I answered:
“The number of holdings”.
Holding conviction
It is a simple measure but can highlight some important characteristics. The first is conviction.
Conviction is an important contributor to relative performance, as it gives a flavour of the strategy’s investment philosophy – why the manager selects certain investments and rejects others. It is this process that differentiates a portfolio from the broader market and can drive alpha generation.
The inference is that the lower the number of holdings, the greater the conviction. We tend to all know what we really like… but only up to a point.
If in doubt, just ask yourself what your two favourite ice-cream flavours are – mine are vanilla and chocolate, despite an occasional dalliance with salted caramel.
Now, try to determine your eighth, ninth, tenth favourite flavours. Accurately ordering them isn’t easy and neither is being able to say how much more the eighth is preferred to the ninth or tenth.
It is the same with investment ideas.
Each incremental holding is not expected to be as good as the one that precedes it. Yet, each holding will be funded with capital that could have been invested in one of the higher-conviction ideas. This diversion of capital from ‘good’ to ‘less-good’ ideas puts an opportunity cost on performance.
Can more really be more?
It isn’t necessarily the case that fewer holdings are always better – portfolios with too few holdings can be blown off-course by unexpected events.
Additional holdings bring with them greater diversification. Investing is all about being rewarded for taking risks and every holding offers exposure to a varied number of risks.
Some risks may be considered desirable and make the holding attractive. Others are undesirable or unintended. Too few holdings could imply an undiversified portfolio that is susceptible to unintended incidental risks damaging returns.
Unfortunately, the investment environment is complex and risk events are not uncommon. This leads to inevitable tension between having fewer holdings to preserve conviction and adding more to diversify incidental risks.
Managing the trade-off
Constructing the optimal portfolio is a challenge every manager faces, while an investors’ view of what is optimal varies with the degree of risk they are comfortable taking.
But what’s broadly agreed on is that there comes a point after which the diversification gains from each additional holding diminishes – taken too far and a portfolio’s return will become indistinguishable from that of the market.
The number of holdings can also play into ESG considerations. These are often contextual issues woven into a company’s story, requiring research effort and qualitative judgement to understand properly. But taking the time to investigate and incorporate them into the investment decision can add to overall conviction. They support better-informed decisions, leading to improved investment outcomes.
The difficulty is that ESG research takes time and resource, both during the due diligence process prior to investing and then post investing through active engagement. It provides an opportunity to enhance investment returns – through better-informed decisions – but becomes harder to do the greater the number of portfolio holdings.
Reflecting on a tough question
My colleague’s question put me on the spot, and there will always be valid factors that are missed when relying on a single data point, but I stand by my answer – the number of holdings offers a window into conviction, investment philosophy, risk management and ESG considerations. I believe it’s a great starting point for investment investigations.
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