Conventional theory says investors should hold a well-diversified portfolio, that markets are efficient, and the best bet is to maximize diversification and not actively manage portfolios. It’s a strategy that tends to work; most money managers don’t beat the passive index.
Running counter to this are portfolios that are more concentrated, and there is a worldwide industry of active management by money managers who are not diversifying.
My colleagues Nicole Choi of the University of Wyoming, Hilla Skiba of Colorado State University, and Tatyana Sokolyk of Brock University and I wanted to understand if there is a behavioral bias or rationale for these less-diversified portfolios. The answer, in our paper, “Portfolio Concentration and Performance of Institutional Investors Worldwide,” came from testing a recent theory of information advantage put forward by two other researchers.
With information advantage, professional investors have acquired knowledge about certain markets or securities that gives them an advantage over other investors. There has been some evidence of this happening in U.S. markets and isolated studies have shown it in a few other countries, but we look at the global picture. Using data from Factset on the holdings of more than 10,000 institutional investors from 72 different countries, we researched the investors’ performance in a variety of funds including mutual funds, hedge funds, and other institutional investments.
We examined three measures of portfolio concentration: home bias, foreign country concentration, and industry concentration. We used two measures of institutional investors’ performance: overall portfolio performance and performance of the part of the portfolio invested in a target country.
The results? We find that there is a positive relationship between portfolio concentration and fund performance, as these investors are able to exploit their information advantage.
An illustration of how this works is seen in commonly observed “home-biased” portfolios where investors tend to invest more in their home countries than they do in what the conventional theory would suggest.
For example, the U.S. stock market, because of its size, should have a big weight in a well-diversified portfolio. Italy is much smaller, so the amount of a portfolio invested in Italy would be much smaller. Instead, with home bias, an Italian investor significantly over-weights the Italian market in a portfolio relative to what it should be in the global market.
Our research shows there is some positive performance due to this home bias, and it’s not just isolated to specific countries or kinds of investments. This validates the theory that these portfolio concentrations aren’t due to behavioral biases but more geared toward information advantage and rational decision-making.
This doesn’t necessarily translate into performance that goes to individual investors. We look at the gross returns of the portfolios, not accounting for manager fees or expenses. We’re not looking at the individual investors who invest in these funds, we’re looking at whether the manager is able to harvest any gains from this portfolio concentration. We do find those gains, which illustrates that expertise is involved.
While we are not looking to measure the net effects, passive investors do benefit indirectly from this information production. The information gleaned by managers investing in the concentrated portfolios works its way into market prices. Even if management fees eat up the entire performance benefit they are ultimately producing information that leads to prices that reflect a good amount of this information.
Our research is not offering an investment strategy of concentrated portfolios, or suggesting that individual investors look into them. What we are looking at are the people who have information advantage and whether they are able to maintain and exploit this advantage over time.
What our research does suggest is that concentrated portfolios are pursued for information-driven reasons and produce optimal results. The institutional investors’ concentrated portfolios created through information advantage might not be something that benefits the individual investors, but it’s a rational approach that can benefit the market with fair returns.
Read the full paper, “Portfolio Concentration and Performance of Institutional Investors Worldwide,” to be published by the Journal of Financial Economics.
Mark Fedenia is Patrick A. Thiele Chair in Finance, and associate professor of finance at the Wisconsin School of Business.