Investing by numbers: how many shares should a fund hold?

What matters most when investing in shares – a small number of punchy positions that really make a difference to performance or a high level of diversification?

When it comes to equity funds what is the magic number of underlying holdings? Is it a case of quality over quantity or the more the merrier? We weigh up the pros and cons of four different approaches.

The concentrated approach

Most investment managers we canvassed endorse concentrated approaches of 20 to 40 shares.

A lot of empirical data supports this type of strategy. Numerous studies on the US and UK stock markets show that the benefits of diversification almost disappear after you have invested in 25 stocks.

“Indeed, a higher number of securities can lead to what has been coined ‘diworsification’,” says Simon Temple-Pedersen, an investment director at JM Finn.

While counterintuitive, risk can be lower in concentrated portfolios. “An investor ought to know his smaller number of holdings in great detail and be much more aware of potential risk factors,” says Kamal Warraich, an investment analyst at Canaccord Genuity Wealth Management.

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Fund managers who adopt a concentrated approach tend to be focused on a single investment style. In the short term, that inevitably leads to meaningful performance deviation – both positive and negative. Until recently, ‘value’ funds had lost out to ‘growth’ ones for some time. Over the longer term, when style headwinds are more likely to wash out of performance data, concentrated managers who are skilled stock-pickers typically do well.

These tend to be ‘best ideas’ portfolios and studies show that a small minority of companies account for disproportionately high returns. Hendrik Bessembinder of Arizona State University found that 4% of the 26,000 companies listed in the US between 1926 and 2016 accounted for most of the wealth creation.

“The Holy Grail is to identify a highly concentrated fund that has an eye for such companies while not feeling compelled to own the noise,” says James Sullivan, head of partnerships at Tyndall Investment Management. “Just like the Holy Grail, it’s never likely to be found in perfect form but there will always be some impressive replicas.”

Funds in the Lindsell Train and Fundsmith stables are popular choices with fund selectors. LF Lindsell Train UK Equity, run by Nick Train, and Fundsmith Equity, run by Terry Smith, own just 26 and 29 UK and global shares, respectively. Both are among the interactive investor Super 60.

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Another constituent and favourite of Tyndall’s is Lindsell Train Japanese Equity, which is run by Michael Lindsell and has only 22 holdings. “It’s very much at the concentrated end of the spectrum and has underperformed the Topix in the recent past but done exceptionally well over his tenure,” says Sullivan. The fund is also a member of the interactive investor Super 60.

As well as Fundsmith and Lindsell Train, JM Finn highlights Trojan Global Equity, which has 27 holdings. “What these three fund houses have in common is not only relative concentration in their funds, but a bias towards large names, leading me to being happy to include such offerings in virtually all client portfolios,” says Temple-Pedersen.

Other concentrated approaches to UK and global equities include Baillie Gifford Positive Change with 33 global holdings, used by Canaccord Genuity, and VT Downing Unique Opportunities, a UK equities fund with 32 holdings used by Nexus Investment Managers. Baillie Gifford Positive Change is also a member of interactive investor’s ACE 40.

“The risk-adjusted return is one of the most important criteria for us – a concentrated approach doesn’t mean the fund’s volatility is higher,” says Nexus portfolio manager Lucy Kupczak.

In US and Asia-Pacific equities, Quilter Cheviot rates Vulcan Value Equity fund, which owns 24 value stocks, and Fidelity Asia Pacific Opportunities, which has 33 holdings and a strong growth bias. Nick Wood, head of fund research at Quilter Cheviot, sounds a note of caution, particularly given such narrow regional and style focuses: “It’s important for investors to hold concentrated funds as part of a diversified strategy, not just one or two in isolation.”

The equally weighted approach

Few funds take an equally weighted approach, splitting assets equally between holdings, but Guinness Asset Management is a big proponent. It also believes investment managers should have high conviction in the stocks they own, so its funds are concentrated. Super 60 constituent Guinness Asian Equity Income has 36 equally weighted holdings.

Guinness says its approach has several advantages. It reduces stock-specific risk as it cannot be overweight a small number of favourite companies. It also instils a strong sell discipline. Managers must sell a position to make way for a new one, so must continually assess the companies they own relative to the rest of the universe and have real conviction to make a change.

The benchmark-aware approach

Quilter Cheviot invests in funds that adopt all four approaches to some degree, although mostly those that run concentrated or benchmark-aware funds.

“The benchmark-aware approach is a broach church,” says Wood. “Managers range from index huggers to much higher risk. There are plenty of fund managers out there holding more than 40 stocks who would claim to be index aware.”

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Benchmark-aware managers take bets at a stock or sector level relative to reference index exposures. By their nature, these funds tend to be diversified with active shares (divergences from the benchmark) that are lower than those of concentrated funds. Quilter Cheviot uses Artemis Income, which typically has 50 to 70 stocks, Janus Henderson European Selected Opportunities, which has almost 60, and JPM Emerging Markets, a Super 60 fund, which owns around 70. They had active shares of 72%, 60% and 68% respectively, whereas many concentrated funds have 95% or more.

Their performance records are largely good. The Artemis and JP Morgan funds have beaten their benchmarks over one, three, five and 10 years. The former has trebled the return of the FTSE All-Share since its launch in June 2000, making it the top performer out of 25 funds with a 20-year track record in the IA UK Equity Income sector. The Janus Henderson fund has beaten the index over three and 10 years but underperformed over one and five.

The diversified approach

“When the monster stops growing, it dies. It can’t stay one size,” writes John Steinbeck in The Grapes of Wrath. For Sullivan, it is a pertinent quotation. “Funds that grow from nimble to supertanker have a tendency to become more consensual,” he says. “Those that increasingly seek solace in the benchmark by adopting an overly diversified approach will lose the battle in the active/passive debate, becoming moribund.”

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When seeking broad exposure to a certain market, Tyndall and Nexus prefer to blend passive vehicles with concentrated active funds.

Others, such as Quilter Cheviot and Canaccord Genuity, favour diversified portfolios in higher-risk active strategies where there is more uncertainty in outcomes, such as smaller companies, or sectoral funds where exposure is concentrated on similar business models such as technology (Polar Capital Technology Trust (LSE:PCT) has 110 holdings) and biotechnology (Biotech Growth Trust (LSE:BIOG) has 80).

Richard Garland, a portfolio manager at Berenberg, the investment bank, says: “A long tail of investments may be the result of a strategy of ‘playing the numbers’ rather than diversification. By investing in many small companies, the manager increases the chances of finding tomorrow’s market leaders while they’re still small.”

This sentiment could apply to the mighty Scottish Mortgage (LSE:SMT). Three-quarters of its portfolio is concentrated in 30 holdings, but it owns 97 stocks overall, including 50 private companies that account for less than 20% of assets.

The mix and match approach is best

So, which approach is best? For Ben Yearsley, a director of Shore Financial Planning “there is no right answer”. Instinctively, he feels fewer is better, but the approach should depend on the reason for the investment and time horizon.

“You can’t look at anything in isolation without the wider context of what the fund is trying to achieve, what the benchmark looks like and what peers are doing,” he says. “Buying 200 risky small companies, some of which fail, could give you a better return than a large company portfolio with only 20 that happens to perform in line with the index.”