Fewer Stocks, Higher Potential: The Rise of Concentrated Active ETFs

High conviction might be the way to go for superior long-term gains.

And with the growth of active ETFs, more high conviction funds could be coming to a portfolio near you. While not broad index fund replacements, these new ETFs could serve as a top way to boost returns and meet goals.

John Bogle’s creation—the index fund—was designed to instantly create diversification. By owning the entire market, you could instantly hold 500, 1,500 or even 3,000 stocks depending on the index. This diversification is wonderful at reducing risk. If Microsoft has a bad quarter and sees its stock price decline, Apple’s positive quarter and price increase will help reduce the losses.

But it also may not be great at getting above average returns. It turns out that diversification does have a downside. This is where concentration may have an upper hand.

Dubbed high conviction investing, this area is especially suited to active management. Here, a fund manager will put all their eggs in one basket, eschewing diversification for just 10, 20 or 40 holdings.

The idea is that managers get to know a business and rely on deeper research than other managers holding 200 or so stocks. As such, high conviction picks are made with more certainty. Moreover, there is more of a return to a concept of what equity ownership really is: buying a piece of a business. Ownership is made because the underlying business and its fundamentals are strong.

As for diversification, a series of joint papers between MIT, LSE, and Goldman Sachs suggests that holding only 20 stocks is enough to reduce unsystematic risk by 90% to 95%. You don’t need to own the entire market to get the benefit.

And yet, those concentrated bets could provide better returns. According to renowned economist Eugene Fama, over the longer term, stock selection matters more than factor selection. This chart from Morgan Stanley highlights just how much selecting the right stocks drives returns. ¹

Source: Morgan Stanley

And does concentration truly boost returns? The MIT, LSE, and Goldman Sachs joint study showed that managers willing to make ‘big bets’ and have high conviction in a small number of stocks managed to deliver approximately 30 basis points of additional performance each month, or roughly 4 full percentage points of additional return each year than those that focused on broad ‘diversified’ holdings. These managers also managed to outperform their benchmarks by 1% to 2.5% each quarter depending on their benchmark.

The best part is that more high conviction funds could be coming to our portfolios soon. That is, if asset manager Janus Henderson has its way.

In a recent interview with Janus Henderson subsidiary Tablua, CEO Michael John Lytle called the potential for high conviction active ETFs “compelling” and that the idea was ripe for disruption. The firm recently launched two new ETFs in Europe that follow the high conviction theme by holding just 20 to 30 stocks. Here at home, Janus has several mutual funds that follow concentrated best idea portfolios. So a launch in the U.S. is possible.

Moreover, several other niche asset managers—such as Baron, Jennison, and Akre—as well as big names like Fidelity and T. Rowe Price have successful high conviction strategies that could be ported over to ETFs.

And there are plenty of reasons why asset managers would want to choose the ETF structure to help launch these products.

For starters, the structure of ETFs can help eliminate bloat and keep funds from getting too big. That’s because of ETFs’ dual ownership structure. Regular investors can buy ETFs on the secondary market. However, ETFs are created by authorized participants (APs). These APs are key to the creation and redemption mechanism. APs exchange assets or cash to physically start the ETF shares. Likewise, they accept assets back from the funds. This helps solve the bloat issue and keep funds concentrated. New money entering the fund can be in shares of stock. Better still is that active ETFs are fully invested, eliminating any cash drag.

Second, ETFs already feature lower expense ratios than other active vehicles. This helps reduce the fee hurdle and allows active ETFs to shine when it comes to active management. That outperformance can be enhanced when it comes to concentrated portfolios. Those funds that tend to be more concentrated often charge more than lower concentrated funds according to Morningstar data. That’s because they have to spend more money on research to find the best ideas.

All in all, high concentration funds are another way that active ETFs can win for portfolios. As more of these products launch, they can serve as a spice to a broad portfolio or in the ‘explore’ side of a core/explore model. There are some concentrated funds already on the market, albeit not necessarily high conviction funds with only a small smattering of holdings.

These funds are selected based on exposure to U.S. equities with a concentrated tilt as well as assets under management. They are sorted by their one-year total returns, which range from 4% to 45%. They have expenses between 0.17% to 0.55% and assets under management between $2.5B and $21B. They are currently yielding between 0.17% and 4.8%.

Concentrated funds are coming and active ETFs are the way that investors will win with regard to these fund types. Holding fewer stocks still provides diversification and potentially outsized returns. Investors may want to consider them for their portfolios.

Diversification isn’t what it’s all cracked up to be. High conviction stock funds may be better performers. And now, active ETFs are enhancing those abilities. With more launches planned, investors have plenty of choice in adding these vehicles to their portfolios for outsized long-term returns.

¹ Morgan Stanley (October 2018). Long-Term Conviction in a Short-Term World