Is there a perfect number of stocks for a portfolio?

Running a concentrated portfolio of a small number of companies comes with the risk of a single-stock failure, which can derail a fund manager’s track record. Too many, and a manager risks limp, index-like returns. Smaller positions may bring necessary diversification, or could show a lack of focus. In reality, the “right” number may depend on the manager’s style, and where they invest.  

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The vogue has been for managers to hold concentrated portfolios. Many have sought to emulate the Warren Buffett mantra - “keep all your eggs in one basket, but watch that basket closely.” The Berkshire Hathaway portfolio has around 50 stocks, with the top 10 representing more than 80% of the company’s holdings.

However, there are alternative approaches. The £5.9 billion F&C Investment Trust (LSE:FCIT), for example, has more than 400 holdings. While this may seem like a lot, it is less than one-tenth of the holdings in its benchmark, the FTSE All World index.

Those in favour of a concentrated portfolio will argue that a smaller portfolio shows conviction and focus. Dan Brocklebank, head of UK at Orbis Investments, believes investors need to consider a manager’s capacity.

He says: “Our edge is to have an idiosyncratic view on a company. What is it we believe that is different to the market? Is the market overreacting to this or under-reacting to that? Those views are quite rare and hard to find. The limiting factor is time in the day and brainpower. Against that background, why would I add to my 21st favourite company when I could add more to my top five?”

Case for diversification

Brocklebank points out that fund managers can end up with large portfolios for a variety of negative reasons: “A fund becomes successful but the fund group leaves it open too long. Cash is going in, and the manager can’t deploy it in the type of stocks they used to invest in.” This creates style drift. Equally, it may be the result of a poor sell discipline: the manager simply can’t bear to part with stocks on which they’ve made a loss and keep hoping they will come good.

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Those with larger portfolios will make the case for diversification. Paul Niven, manager of the F&C investment trust, says: “There has been a trend for investors to seek more focus in their equity portfolios, with a view that ‘less is more’ with respect to the number of stocks. Whether a highly focused, or more diversified, portfolio is appropriate for an end investor will, in part, depends on their circumstances and objectives.

“An appropriately diversified portfolio reduces the overall volatility of the portfolio and also minimises timing risks, overexposure at any one time to a strategy that subsequently underperforms. Second, a diversified approach will be more likely than a focused approach to include the small number of winners that tend to drive overall returns. Third, diversification tends to improve the ‘efficiency’ of the portfolio, with better returns per unit of risk.”

He points to studies such as those from Professor Bessembinder of Arizona State University in 2018 that show a small proportion of stocks account for the vast majority of wealth creation. The Bessembinder study found that only 4% of the stocks in the sample (1926-2016) accounted for all of the wealth creation over the period. Niven’s view is that highly focused portfolios have less chance of exposure to these winners.

Messy reality

The reality is complicated – neither a fund’s diversification, risk or performance is necessarily influenced by the number of companies. Brocklebank points out that achieving diversification is more complicated than simply holding lots of companies. “It helps with some risks, but not all of them.” Holding lots of companies may minimise the impact of an individual stock failure, but it does not mitigate against, say, the impact of higher interest rates, or oil prices.

He adds: “It depends how correlated the stocks are. Do they move together? And do they move to the same extent? 10 utility stocks, or 10 airline stocks will not be a diversified portfolio.”

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Equally, Niven says the academic literature does not support the idea that having a high active share (i.e. a significant difference from a fund’s benchmark) is a route to high returns. He says: “Studies such as Cremers and Petajisto (2009) and Petajisto (2013) have been used to promote the notion that the more active an approach is, the more likely it is to outperform. Yet subsequent work debunks this view and reaches the more logical conclusion that high active risk is no meaningful predictor of excess returns.”

Mark Preskett, portfolio manager for Morningstar UK, says that making assumptions about tracking error, active share and volatility may not lead to the right conclusions. He adds: “The WS Lindsell Train UK Equity fund has a high active share and tracking error, but because of the type of stocks manager Nick Train picks, the volatility is very low. The Jupiter UK Alpha has a low active share and a low tracking error because it holds a lot of large caps, but its volatility is much higher. Dimensional UK Value has 230 stocks, but its volatility is high because it emphasises smaller companies.”

James Carthew, head of investment company research at QuotedData, compares two extremes - Manchester & London Ord (LSE:MNL) and Herald (LSE:HRI) investment trust. Both have a strong focus on technology, but the first trust operates with a very focused portfolio with over half of the portfolio in two stocks. Carthew says: “Mark Sheppard, the manager is passionate about artificial intelligence (AI) and the transformation that it will wreak on the global economy. The two mega-cap leading positions – NVIDIA Corp (NASDAQ:NVDA) and Microsoft Corp (NASDAQ:MSFT) – he sees as the main beneficiaries of this.”

In contrast, Herald invests in small and medium-sized companies, which can be more volatile. Their businesses are less broadly based and sometimes exposed to binary outcomes where success or failure can be hard to predict. At the end of April, manager Katie Potts was invested across 326 companies. Carthew says: “The winners can multiply in value and grow to be reasonably sizeable positions – the largest, Super Micro Computer Inc (NASDAQ:SMCI), was 4.3% of the portfolio at end April. The losers can go bust without making much of a dent in shareholders’ capital”.

He believes both approaches have a place. Carthew notes: “The decision to run with a focused or a highly diversified portfolio depends on your attitude to risk/reward and how likely it is that the company that you are investing in might turn out to be worthless.”

Manchester & London has performed better than Herald, but the picture may have looked very different if Nvidia or Microsoft had a rough patch or the AI growth thesis took an unexpected turn.

Different asset classes 

There are areas where managers will need to hold more companies to manage risk effectively. In smaller companies, for example, fund managers need to be prepared for the unexpected, and holding a greater number of stocks can cushion the blow from a single stock failure.

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Ryan Lightfoot-Aminoff, investment trust research analyst at Kepler Partners, points to funds such as Miton UK Microcap (LSE:MINI) trust, which has almost 140 holdings. “The index has a large amount of under-researched but potentially attractive ideas, which means managers can be spoilt for choice. By having a long tail, managers Gervais Williams and Martin Turner can hold a wide range of potentially exciting technologies and new ideas without missing out. Micro-cap companies can also be volatile, so a diversified approach can help dampen this effect.”

More holdings may also be useful for income funds. Lightfoot-Aminoff says the City of London (LSE:CTY) trust has more than 80 holdings, which gives the manager a range of income sources, helping support the trust’s objective of growing income over time.  

Bond funds will also hold lots of names. Preskett says: “There is an asymmetric payout. The manager invests to draw the coupon from the bond and get their money back at maturity, therefore it makes sense to have a lot of holdings. More concentrated corporate bond funds have been tried, but a single default can put a material dent in a fund’s performance.”

Holding a larger number of stocks is a valid approach, as long as it is being done for the right reasons. It may contribute to diversification and it may help ensure that a strategy has exposure to the small number of winning stocks. On the flip side, active investment isn’t always a pathway to riches. Preskett concludes: “A high number of stocks doesn’t rule a fund out as a credible investment, but the manager needs to deliver genuine alpha. When a fund manager spreads their bets, they have to work harder to do that.”