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What is the best way to invest in global equities?

Andrew Miles  |  07 Jun 2018Text size  Decrease  Increase  |  
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The debate between the merits of concentrated and diversified portfolios is always a hot topic. But research shows why a more concentrated portfolio doesn’t necessarily lead to better excess returns.

What makes a portfolio concentrated?

First, let’s define what a concentrated portfolio is. We think of global equity portfolios of 20-40 stocks as concentrated, and less than 20 as extremely concentrated. This means that we define less than 10 per cent of our coverage as concentrated or extremely concentrated, which amounts to seven strategies. It should be noted, however, these strategies account for a significant chunk of assets under management.

Is a concentrated approach necessary for global equities?

Champions of a concentrated approach argue that a high-conviction style is required to beat the benchmark. However, we think the argument is more nuanced. Any decision to go down the concentrated route should consider the investible universe.

In the domestic equity market, being meaningfully different from the narrow S&P/ASX 200 can be tricky. The five largest stocks account for more than 30 per cent of the index and are often the usual suspects: the major banks and miners. By contrast, the five largest stocks in the MSCI World Index sum to about 7 per cent, admittedly, technology stocks feature heavily at the time of writing.

We think the more-diversified global market makes it easier for managers to differentiate themselves from the index without having to be overly concentrated. To that end, even global portfolio managers with 100 stocks in the portfolio can look very different from the benchmark, evidenced by high active shares.

For example, Capital Group New Perspective 40984 has 250 stocks in the portfolio and can still achieve an active share of 70 per cent, that is, 70 per cent of the fund is different from the index. Similarly, MFS Global Equity 4532 has an active share of almost 90 per cent, with a diversified portfolio of nearly 90 stocks.

Do concentrated portfolios perform better?

From our analysis of large-cap global equity managers, there isn’t a strong relationship between the degree of concentration and positive excess returns. Portfolios with fewer than 50 stocks have more-dispersed excess returns, but the majority of these are negative.

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As the number of holdings increase, the dispersion declines, but the negative bias persists. For portfolios in the 150–300 range, the excess returns are clustered between 0 per cent and negative 5 per cent.

While there isn't a strong link between concentration and outperformance, there is an interesting relationship between the behaviour of returns in bull and bear markets.

In a bull market, when the index is rising, strategies tend to have a higher correlation, so managers' returns behave similarly to the benchmark in buoyant markets. Interestingly, in a bear market, when the index is falling, the correlations are more dispersed and tend to be lower, which is positive trait for the more concentrated manager, many of whom exhibit a quality bias that should help protect on the downside.

Investment style

It is important to remember that all investment styles go in and out of favour. When a style is unfashionable, relative performance can struggle. This can be exacerbated with a concentrated approach where the investment style can be more pronounced. Take MFS Global Equity 4532, which has three times as many holdings as MFS Concentrated Global Equity 16989; 90 versus 30. Though both portfolios are managed by the same outstanding team applying a similar judicious process since their common inception in 2009, the concentrated version has outpaced the diversified version.

But, in 2011, when stock markets fell on concerns in Europe, MFS' favoured hunting ground, the concentrated strategy suffered a larger drawdown than the diversified version. Nevertheless, both of MFS' strategies fared much better than the index, owing to their defensive style.

No one is perfect, not even portfolio managers

In addition to investment style risk, it's worth remembering that even the best investors can make a bad investment. Orbis Global Equity 41069 boasts a group of talented stock-pickers who have contributed to an outstanding track record.

Even these highly skilled practitioners have a 56 per cent success rate since the fund's 1990 inception. Individual stock missteps are an inevitable outcome and are amplified in a concentrated portfolio. So, when a previously clairvoyant portfolio manager has temporarily lost their Midas touch, being diversified can soften the blow.

True diversification

Regardless of the number of stocks in the portfolio, it's important to understand what you hold and whether the names are truly diversified. Often, on the surface, a portfolio can appear diversified only to be exposed to similar risks. We've encouraged managers to disclose full portfolio holdings to help investors in this regard.

Grant Samuel Epoch Global Equity Shareholder Yield 16301 has a diversified portfolio, containing 90-120 stocks. However, Epoch's penchant for high-dividend-paying stocks can make it susceptible to singular risks, such as changes in interest rates.

Indeed, periods of weak relative performance have coincided with sharp increases in bond yields. We wouldn't advise trying to pick a global equity strategy based on the future direction of interest rates in the short term, but it is worth noting the types of stocks in a portfolio and their sensitivities to particular risks.

Conclusion

The decision to adopt a concentrated approach should include an analysis of the investible universe. Unlike the domestic equity market, a diversified global equity portfolio can look and behave very differently from the index.

From our analysis, there doesn't appear to be a strong relationship between degree of concentration and positive excess returns. In fact, the majority of active managers have underperformed the index over the past 10 years. However, active managers are less correlated in down-markets compared with up-markets, which is a positive trait.

It's also important to understand your own temperament as an investor, and whether you can stomach periods of underperformance and high volatility that can accompany a concentrated portfolio. We therefore advise using them in a supporting role, which means they should be used in conjunction with other funds.

 

is an Analyst, Manager Research, for Morningstar Australia

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