The Decision to Concentrate: Active Management, Manager Skill, and Portfolio Size

Abstract

Several recent studies establish that more highly concentrated portfolios produce superior risk-adjusted returns. The untested premise of this literature is that it is the most skillful managers who hold the most concentrated portfolios. In this study, we formally examine the implicit assertion that the initial portfolio concentration decision is meaningfully related to a manager’s inherent investment skill. First, we present a simple theoretical model showing that the greater the manager’s skill level, the more concentrated the portfolio should be. Second, we conduct an extensive simulation analysis of the capacity to make accurate ex ante security return forecasts and show that skilled managers would select only about 3-20% of the available securities and that the portfolio concentration decision is directly proportional to investment prowess. Finally, we provide an empirical examination of the actual skill-concentration relationship for actively managed U.S. equity funds over 2002-2015, documenting that managers who demonstrated skill in the past do form portfolios with higher concentration levels. We conclude that talented asset managers should and actually do hold more concentrated portfolios and that the extent of this concentration decision is meaningfully related to forecasting skill.

Keywords: Portfolio Concentration, Manager Selection Skill, Forecast Accuracy

JEL Classification: G11, G17