13 May 2024

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The Myth of the Superstar Fund Manager

Luigi Campopiano

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When it comes to diversification, there's a difference between what's recommended to individual investors and the modus operandi of professionals: while high diversification is often advocated as the golden rule for individual investors, for "superstar" fund managers, the key to achieving stratospheric performance often lies in narrowing down the field to fewer securities.

The most famous example of this concentrated approach is the one that has always characterized Warren Buffett's style: the number of stocks in his Berkshire Hathaway portfolio is usually around fifty because he prefers strong bets on a few companies whose business he strongly believes in. It's a clear contradiction of the adage "don't put all your eggs in one basket." As is well known, for Buffett, the strategy has worked over the long term: between 1965 and 2021, Berkshire Hathaway produced a compounded return of 20% compared to the S&P 500's 10.5%.

Another famous example of this concentrated approach, which has stirred much excitement in recent years, is Cathie Wood and her Ark ETF: just 28 stocks in the portfolio, focused on the tech and biotech sectors. A strategy that has significantly increased the fund's volatility compared to that of the S&P 500 and which, over a five-year period (as of February 2022), did not pay off due to the collapse of technology stocks following the rise in interest rates.

The myth of careful stock selection to beat the market, known as "stock picking," continues to be fueled by success stories, but once again, statistics should discourage such an approach. Plato Investment Research wanted to test the idea that narrowing diversification could be a factor correlated with better results (Morningstar database).

As diversification increases, as can be seen from the graph, the difference between the performance of funds and that of the benchmark index narrows. It's interesting to note that in 2022, during a bear market, concentrated investments on average worsened the market's average performance, despite the fact that limiting volatility is often one of the selling points of these solutions in times of crisis.

A previous study conducted by Morningstar over a broader period, 1994-2018, showed that there was no significant difference in performance between more and less diversified funds. Neither better nor worse. However, since history doesn't end with average return statistics, as Morningstar pointed out, the risk of encountering a "poor" manager increases with less diversified funds, as concentrated portfolios have a wider range of potential returns compared to their more broadly diversified counterparts. In some fund categories, concentration on specific sectors can also increase volatility risk.

While there isn't a significant relationship between concentration and gross returns, there's no evidence of significantly better chances of outperformance. Finding the superstar manager in their magical moment is a matter of luck (the data says so). But it's always nice to dream.