Market Update 2nd March 2026
Concentration Levels
Morningstar released an interesting report last week about fund concentration. Broadly speaking it says that more concentrated funds tend to do less well which will probably come as a surprise to at least some people.
When you meet a lot of funds, as we do, you tend to find there are a wide range of opinions about almost all aspects of fund management and portfolio construction – including concentration. The received wisdom (I think) is that concentration is usually a good thing. The manager will typically have a lot to say about “conviction” or the depth of knowledge they have about whatever it is they do, or how big their analyst team is and how diligently they do absolutely everything. It all sounds like something you would want to pay for and sometimes it can be.
There are some exceptions. One extremely successful global equity fund we hold makes a virtue of being contrarian on many issues. They avoid meeting CEOs for example. Most managers like to tell you about “access” and relationships, sometimes even how the CEO listens to them and takes their advice about running the company. This fund thinks a meeting with the CEO is just an opportunity for the CEO to sell them whatever ropey story they are telling this time and they are better off not knowing.
On concentration they acknowledge that even a successful manager is going to be wrong a high percentage of the time. For them this has two implications – one it makes sense to spread yourself thinly and second, related to this, don’t get too attached or entrenched in individual positions. Implicit in conviction is a high level of confidence which can be hard to shake if things start to go wrong.
But I am regularly confused about our industry’s apparent willingness to take a lot of this at face value. Are there any definitive answers to these questions or does it all depend, or six of one and half a dozen of the other, let’s just agree to disagree and go for a beer later?
If you are going to pass judgement on the idea of concentration in a fund, then I think the key question is does it work? Can the fund manager prove a track record of being right a significant percentage of the time?
A 1995 paper by Richard Grinold and Ronald Khan came up with an “information coefficient” (IC). This is the correlation between a manager’s forecast and the actual outcome. In other words, are they right? They propose multiplying this by the square root of “breadth” (the number of independent decisions they make) to come up with an information ratio (IR) – a measure of excess return per unit of risk taken. I will come back to the importance of independence.
Several other papers have built on this work and tried to use it to back out a minimum hit rate. How much edge do you need to generate a high enough hit rate to be successful?
I don’t want to go too much into the maths but will try to explain around it.
The maths tries to isolate the manager’s edge or how it is different from a coin toss with a 50% chance of being right.
Let’s say your hit rate is 51% – only slightly better than tossing a coin. If you apply your 51% skill set to one stock pick, it’s not going to make a lot of difference and I for one would not pay you to do this. If you apply it to 10 stocks you might start to notice, even more so with 100. If you can stay gainfully employed for long enough people might even start mistaking all this for some kind of genius, including you.
But here’s the thing. It’s not linear – it doesn’t go in a straight line. 100 stocks with a 51% hit rate aren’t 10 times better than doing it with 10 stocks.
At a fund level we can illustrate what this means with a concentrated 40 stock fund vs a less concentrated 200 stock fund. 200 is 5 x 40, but your added value doesn’t increase 5 times by going from 40 to 200. Straying back to the maths for a minute this is where the square root comes in – it is the square root of 5 which is 2.2x.
Even 2.2x assumes that you can apply equal skill to every decision and even more importantly assumes each decision is independent. Neither are likely to be true if you’re a fund manager. You almost certainly have more knowledge of some areas than others. You might know more about banks than you do about AI. Your 51% is an average.
The decisions are also unlikely to be independent of each other, because your fund is likely to be focused on something, whether it is a region, a sector, a theme, a style (such as value or growth), or other factors such as size. Maybe you think interest rates are falling and buy several stocks to overweight a sector you think will benefit from this, then turn out to be wrong.
Don’t forget from earlier, breadth isn’t the number of stocks, it is the number of independent decisions made. If your fund has three banks and four tech stocks in it, then breadth would call that two positions rather than seven. The lower the breadth the higher your IC needs to be to survive. Even if you have a high IC and are as good as you think you are, you are still asking for trouble one day. Lack of breadth means a small number of related issues going against you can be disastrous, but a 51 percenter can probably roll on with modest IC and some decent risk management.
If you want to know if it is okay for a manager to run a concentrated portfolio it is important to dig a little deeper than tracking error, active share or just counting the number of stocks. These are useful headlines, pointers and potential flags. But in addition, you need to be able to identify – if possible – the number of true economic positions being taken, the correlation between these positions, and how diversified are the sources of alpha in the fund.
I think we know intuitively that a manager running a concentrated fund is going to need to be right more often, but what the maths shows is – to me at least – the imperative to be right goes up surprisingly quickly and quite soon starts to hit improbable levels.
Studies show that successful managers have a hit rate in the range of about 51%-55%. A really good one might be into the higher 50s. Higher information coefficients and information ratios give you a higher probability of stable, regular outperformance. You can do this by being right more often or diversifying more broadly, or both.
An IR of 0.2 gives a probability of a positive year about 60% of the time. To hit this on our 40-stock portfolio with a breadth of 10, you need to be right about 53% of the time – no mean feat. An IR of 0.5 gives a positive year about 70% of the time and to hit this you need to be right about 58% of the time – you’re a superstar here. An IR of 0.8 gives a positive year about 80% of the time and you need to be right about 63% of the time, which is off the charts and probably ending in jail time for you. It is difficult.
Maybe in the end it is true that there aren’t many neat answers to everything and we are continually cross-referencing these variables with many moving parts that are going to be different at different times.
Robert Fullerton – Senior Research Analyst
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