The Fund | Portfolio Management
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 15-30 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.
