We believe that portfolio management, especially decisions about how much of each stock to buy, is a critically important factor for investment success. The Ensemble Fund practices a focused approach and generally owns approximately 15-25 positions at a time. We believe that this level of focus allows us to capture the bulk of the benefits of diversification while keeping our investors’ assets in our best ideas.
The size of any one position in the Fund is based on our conviction in a positive outcome for the investment as well as our assessment of the magnitude of potential return. By prioritizing conviction in a positive outcome over potential upside, we reduce the need for wide diversification. While diversification has become a sort of unquestioned positive concept for much of Wall Street, we believe strongly that more diversification is not always better.
While adding a 50th or 100th idea to a portfolio may slightly reduce the volatility of a portfolio, it also requires adding your 50th or 100th next best idea. Each new position added to a portfolio mathematically reduces the potential for an investor to outperform the market, as eventually adding additional positions will lead to owning the entire market. For investors that desire to earn market returns, low cost indexing is an attractive strategy and one that we believe is a perfectly rational choice for many people. However, for investors who seek to generate returns in excess of the market, the level of diversification must be optimized, not maximized.
The chart below, based on data from the classic book A Random Walk Down Wall Street by Burton Malkiel, shows how adding a third or seventh or fifteenth position to a portfolio materially reduces the volatility of returns. However, by the time a portfolio has twenty or so holdings, the incremental reductions in portfolio volatility from new holdings is very small.
Burton Malkiel, a strong proponent of diversification, says in the book:
“By the time the portfolio contains close to 20 equal-sized and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.”
Of course, holding twenty technology companies or twenty energy companies does not qualify. That is why in thinking about risk reduction we focus on diversifying the business models and revenue sources within our portfolio, rather than on simply increasing the number of stocks that we hold.
By focusing our efforts on twenty or so portfolio holdings, we give ourselves the opportunity to know our companies at a much deeper level than the manager of a portfolio holding hundreds of stocks. The fact is that the average mutual fund owns close to a hundred stocks with some active managers owning two hundred or more. At the Ensemble Fund, we believe that our focused approach is one our core sources of competitive advantage and we struggle to see how active funds that do not focus their portfolio have much chance of outperforming over the long term.
Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus on this website or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing.
Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.
An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.
Distributed by Rafferty Capital Markets, LLC Garden City, NY 11530.