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Concentration vs. Diversification?

Investors Bill Miller of Legg Mason and Evan Bauman of Clearbridge Investments, who both manage funds with over $1.7 billion in assets under management, spoke on a panel at the Schwab Impact Annual Conference in Washington D.C. on unconstrained investing.  They extolled the values of performing extensive research to pick individual stocks and holding concentrated portfolios with a few high conviction positions.     

They received a question from the audience asking their thoughts on diversifying more broadly compared to their highly concentrated active management style.  They thought that while investing in a more diversified manner has a place in the investment world that being more selective was the superior form of investing.

Raffa Wealth Management believes the contrary.  We believe that taking concentrated positions in specific companies, sectors, or countries exposes investors to risks that don’t come with a reliable expectation of a better return.  For example, the Legg Mason fund managed by Bill Miller has done fabulously well over the past year, up over 60%, however over the trailing three years the fund has underperformed its benchmark by 3.7% annually.

While we understand that some concentrated managers do outperform, identifying them in advance is exceedingly difficult.  The Clearbridge fund that Mr. Bauman manages has done very well over the past 10 years, however that has little bearing on how it will do over the next 10 years.  This is borne out by looking at Morningstar rankings.

On December 31, 2004 there were roughly 200 five star rated U.S. equity funds compared to 150 one star funds.  If one believed that the five star funds outperformed due to superior skill, they would expect them to continue to show a higher degree of outperformance.  However, when you compare both groups over the subsequent five years ending December 2009 they have a very similar dispersion of performance.  The five star rated funds showed no persistence in outperformance.  The one-star rated funds performed just as well.

Expense ratios are another head wind for more concentrated funds.  The funds of the presenters have expense ratios of 1.27% and 2.80%.  Compare this to 0.19%, which is the cost of the US equity allocation used by Raffa Wealth Management, and you can see what a tremendous hill these mangers have to climb just to get back to even.    

Finally, they believe in eschewing diversification in favor of focusing on high conviction ideas.  This high concentration can be helpful when they make good stock picks, as the Legg Mason fund has done over the past year, but it opens the funds up for a high degree of volatility and potential significant underperformance.  The Legg Mason fund has trailed heavily over 2012 and 2011.  Also, both the Clearbridge and Legg Mason funds have significantly higher levels of standard deviation than the benchmark.  Having more diversified investments provides a smoother ride and helps avoid the risk of betting on the wrong stocks and paying a heavy price.

We respect Mr. Miller and Mr. Bauman, but we respectfully disagree with their approach.  Hiring an investment manager to pick a few stocks that they believe will outperform will likely leave an investor actively looking for a new manager.

Index Performance                                        Oct.       YTD    Trailing 1 Yr      

US Stock (Russell 3000)                                    4.25%     26.45%      28.99%        
Foreign Stock (FTSE AW ex US)                       3.67%     14.43%      20.85%        
Total US Bond Mkt. (BarCap Aggregate)         0.81%      -1.10%       -1.08%         
Short US Gov. Bonds (BarCap Gov 1-5 Yr)     0.24%      0.19%         0.35%        
Municipal Bonds (BarCap 1-10yr Muni)           0.69%      0.05%        0.18%         
Cash (ML 3Month T-Bill)                                 -0.00%      0.05%       0.09%