By John Drachman
Part 1 explored the heady levels that concentrated fund portfolios have been delivering to investors. This, Part 2 considers the case for investing in “the best of both worlds;” a strategy that combines a concentrated portfolio with greater diversification exposure.
Can alpha seekers pursue the outstanding performance they want – while managing to get the sleep they need?
The current case for a concentrated portfolio is powerful; however, the additional risk of a non-diversified strategy can still spook more conservative investors.
According to a recent capital market study utilizing a database of U.S. equity mutual funds, researchers documented how concentrated portfolios reliably achieved better performance, both on a risk-adjusted and absolute return basis. Additionally, the boutique investment firm Kayne Capital Advisors has pointed out that concentrated portfolios outperformed diversified portfolios over recent five and 10-year periods based on the Russell 3000 Index.
On the flip side, of course, a concentrated portfolio can disappoint investors who pick the wrong investments at the wrong time. With too many “eggs” in too few “baskets,” an investor can hamstring their ability to temper the impact of negative market pressures on their portfolio. Greater diversification on the other hand reduces the downside influence of any one security by keeping their hard-won assets spread across a greater number of investments.
If Goldilocks managed money
Instead of being overly concentrated or overly diversified, a strategy that combines a short, concentrated list of winners with a complementary diversification strategy might provide the kind of ”just right” solution that even Goldilocks would have endorsed. While contemplating the advantages of blending strategies, consider these hybrid approaches:
- Diversification by sector: “Companies in different sectors, driven by a variety of external factors, have low degrees of correlation – this is what diversification means,” says George Calhoun, professor of quantitative finance.
- Diversify across several concentrated funds: Owning a few concentrated funds offers more diversification than holding a single portfolio. For example, investing in three funds comprised of 15 stocks each may be more advantageous for a prudent investor than one fund with 45 stocks.
- Add an index-based fund to your concentrated strategy: A quality index fund or ETF in an investment blend can help mitigate risk while still pursuing an attractive level of return. You can also fine tune your this allocation as your goals change over time.
In general, most of the strategies described here are best carried out by a professional financial advisor. However, it is definitely worth exploring your options early and often so you can make a more informed decision when choosing an advisor to help you execute these strategies. Your professional can help you identify those selections that have a better shot at out-performing the market while still giving you enough diversification so you can sleep at night.
John Drachman is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.