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

Recent research shows that more highly concentrated portfolios produce superior risk-adjusted returns. The untested premise is that it is the most skillful managers who hold the most concentrated portfolios. In this article, the authors formally examine the implicit assertion that the initial portfolio concentration decision is related to a manager's inherent investment skill. First, they present a theoretical model indicating that the greater the manager's skill level, the more concenÂtrated the portfolio should be. Second, they conduct a simulation analysis of the capacity to make accuÂrate ex ante security return forecasts; they show that skilled managers would select as few as 5% of the available securities and that the portfolio concenÂtration decision is directly proportional to investÂment prowess. Finally, they provide an empirical examination of the actual skill-concentration relaÂtionship for actively managed equity mutual funds over 2002-2015 and document that managers who demonstrated past skill do form portfolios with higher concentration levels. The authors conclude that talented asset managers should and actually do hold more concentrated portfolios and that the extent of this concentration decision is meaning fully related to forecasting skill.