Proponents of actively managed, concentrated portfolios will be heartened by the results of a study published recently in the Financial Analyst’s Journal.

The authors, Eitan Goldman, Zhenzhen Sun and Xiyu (Thomas) Zhou, analyzed the returns and portfolio concentration of 3,895 actively managed U.S. equity mutual funds from 1990-2012. They found that funds with a higher level of portfolio concentration within sectors display better performance.

Unlike many practitioners’ studies, the author’s definition of outperformance uses the prevailing academic models for calculating excess returns, or alpha. These models measure the extent of exposure of a fund’s portfolio to dimensions of the market that, on average, historically have outperformed over the long run.

These dimensions, or factors, include excess returns related to the performance of stocks of small companies (which outperform large companies), value stocks (which outperform growth stocks) and high-momentum stocks (which outperform low-momentum stocks).

The alpha calculated for a mutual fund is computed net of the incremental returns associated with the portfolio’s level of factor exposures. Essentially, these models give no credit to an active portfolio manager for simply holding stocks that have exposure to outperforming factors. These portfolio managers get credit only for returns from stock selection in excess of those generated by the market and factor exposures.

Think of it this way: you don’t give credit to a fisherman for pulling an average catch out of a well-known, well-stocked fishing hole. But you would give credit to the fisherman if his collective catches over many years are significantly in excess of the norm. Similarly, neither should a portfolio manager of a small-cap, value fund get credit for the returns associated with its small-cap and value exposures. This is particularly true today, when exchange-traded funds (ETFs) provide low-cost access to dimensions of the market that historically have outperformed.

The annualized alpha of the funds within highest decile of within-sector portfolio concentration (using several measures) was 0.37%-0.57%. Highly concentrated funds, on average, fully covered their costs (although modestly) and realized excess returns. Furthermore, as the funds in the study had an average management expense ratio of 1.24%, their outperformance before the deduction of fees was much stronger. Highly concentrated funds with lower fees, on average, could have provided significant excess returns to their unitholders.

The report on the study concludes that investors should focus on selecting funds with portfolios that are relatively more concentrated in the top few stocks within a sector. Investors also should select funds that are more concentrated in several industries relative to the overall market.

This study points the way to the future of portfolio construction by financial advisors and the role of active management in these portfolios. The core of the portfolio would be passively managed ETFs that replicate market indices in a transparent and extremely low-cost manner. These ETFs focus on deep markets that are highly competitive and have less mispricing of securities and less opportunity for active portfolio managers to add value. Large companyies’ stocks in the U.S. are prime examples.

A separate portfolio component would focus on strategies that have the opportunity to achieve excess returns. Among these will be carefully selected, low-cost active funds with talented portfolio managers whose interests are aligned with their investors and who implement unique, more concentrated strategies.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm.

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