The Hindu Business Line : Is a concentrated portfolio optimal?

Portfolio diversification is about constructing a portfolio of stocks for beta exposure. A concentrated portfolio, on the other hand, is about alpha generation with high associated risks. —

B. Venkatesh

Modern portfolio management is built on the concept of portfolio diversification. A portfolio manager or an individual investor constructs a portfolio with several stocks to diversify the asset price risk. Hedge fund managers, on the other hand, construct concentrated portfolios to generate alpha returns. We recently received a question from a reader: Should individuals construct a diversified or a concentrated portfolio?

There are obvious benefits and risks of holding a concentrated portfolio. The article discusses these issues and shows why such a portfolio is not suitable for all individuals. It also discusses a model that investors can use to measure concentration in mutual fund portfolios.

Diversifying risk

Long-only managers typically prefer portfolio diversification. The reason is not too far to seek. If a portfolio manager bets on select stocks and they fall in value, the portfolio is likely to underperform. That could prompt the investors to redeem their units, causing a decline in asset under management.

Portfolio diversification is built on the fact that some assets are weakly correlated with each other. So, if one stock declines in value, another may not fall as much.

Constructing a portfolio of such assets enhances the risk-adjusted returns. Empirical evidence has suggested that a well-diversified portfolio can be constructed with just 20 stocks.

But portfolio diversification has become more difficult at present.

The problem is the increasing correlation among assets, which has adverse consequences for the diversification process.

In a recent journal paper, Meir Statman of Santa Clara University has argued that the current market condition requires 300 stocks for a truly diversified portfolio! And that could be difficult to construct for an individual investor, and unwieldy to manage for a portfolio manager.

While constructing a truly diversified portfolio may be difficult, it does not automatically mean that a concentrated portfolio is the right answer.

Benefits from concentration

The Capital Asset Pricing Model advocates diversifying company-specific risks and taking exposure to generate market returns from the beta exposure.

Hedge funds go against the basic tenet of this model. They strive to generate alpha returns — returns that are derived from company-specific risk and are often weakly correlated with the market returns.

Alpha returns are generated from active bets on select stocks. Such exposure carries substantial asset price risk. Suppose a portfolio manager has a positive view on Kotak Bank and, therefore, takes a 15 per cent exposure to that stock. What if Kotak Bank declines 10 per cent while the other sectors either stay range-bound or move up?

There is, nevertheless, an obvious advantage in holding a concentrated portfolio. What if the portfolio manager’s bet turns right? If Kotak Bank moves up 10 per cent instead while the market turns down, the manager has generated alpha returns for her investors. The risks associated with a concentrated portfolio is, however, high. This makes such portfolio attractive only for disciplined traders and risk-seeking investors.

Measuring concentration

A concentrated portfolio is not about the number of stocks in a portfolio. Take two portfolios — A and B. Suppose both portfolios have 10 stocks, but portfolio A has 50 per cent exposure to one stock and the balance in equal weights, while portfolio B has equal weights in all stocks. It is clear that portfolio B carries less concentration than portfolio A.

One measure to capture such concentration is derived from the Herfindahl Index, which measures the market concentration in an industry. The Herfindahl Index is measured by the sum of squares of the market share of each firm in an industry. The number ranges from 0 to 10,000; higher the number, greater the concentration.

The Brandes Institute has modified the Herfindhal Index to arrive at a concentration co-efficient for investment portfolios. The institute defines the concentration co-efficient as the inverse of the sum of squares of the stock weights in a portfolio. So, portfolio A has a concentration co-efficient of 3.6 and portfolio B, 10. One way of interpreting the concentrated co-efficient of 3.6 is that this portfolio is equivalent to an equally-weighted portfolio of 4 stocks. So, lower the co-efficient, higher the concentration risk.

Conclusion

A concentrated portfolio structure would fit well as the alpha-generating satellite portfolio within the core-satellite portfolio framework. Strict risk management rules need to be followed to manage such a structure.

One risk management rule can be stop-loss levels based on technical analysis for direct exposure in the stock market. Investors can also construct a concentrated portfolio with one or two sector funds. The risk management rule in such cases can be based on the investor’s risk tolerance levels.

It is important to understand that a concentrated portfolio in itself is not necessary good. Such a structure enables alpha generation only if accompanied by superior security selection skills.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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