Ryan Paterson, research analyst at Thesis Asset Management, has said the widely-held belief that diversification is the key to successful investing has too often been taken to extremes by active managers.
Paterson argued managers who increase the number of holdings in their portfolios beyond 30 stocks in the name of diversification produce a "negligible" benefit from a risk-reduction perspective.
"While there is a widely-held belief that diversification is the key to successful investing, the goal of diversification at the micro level is often taken to extremes and, at times, some managers have exchanged traditional risk control (diversification) for returns," he said.
"Investors can obtain the greatest risk-reduction benefit by introducing roughly 30 stocks to a portfolio."
Furthermore, the research analyst said the industry pressure on fund managers to move away from the benchmark had led them to introduce the concept of active share, a measure which does not guarantee outperformance.
In order to outperform and be deemed skillful, just having a high active share was not enough he said. In addition, the manager must make sure a high percentage of those off-benchmark "bets" count.
"Fund managers posing as active stockpickers and charging higher fees, but whose performance only mirrors the wider market, are coming under intense scrutiny," he added.
"These funds, sometimes called closet trackers, effectively track their benchmarks so closely that most investors would have been better off buying a cheap index-tracking fund."
Instead, Paterson also suggests placing greater emphasis on using information ratios to assess funds.
However, he warned the information ratio can be manipulated by managers through their benchmark choice.
"An investor should therefore carefully consider and question if the benchmark used is suitable for the investment fund strategy."
He concluded: "While we believe active share and the information ratio are powerful tools for assessing the skill of active managers, we would stress investors still need to do their homework."
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