DiWORSEification: Avoid the Scourage of Overdiversification with Best Idea Funds

[GrizzlyRock]

Fellow Corner of BRK community members,

 

Although it is highly likely I'm preaching to the choir here on this board - just figured I would share the original, attached paper.

 

Here is the abstract: "Active investment managers overuse the concept of diversification in the name of safety.  Many active managers overdiversify their funds to reduce portfolio volatility, which in turn reduces the business risk of the active manager at the expense of clients’ return. This diworseification has a deleterious effect on portfolio performance as active managers become closet indexers with high fees.

 

Best idea fund managers realize exemplary investment performance results from security selection and effective position sizing. When hiring an active manager, investors should demand nothing less than skilled capital allocation to the managers’ best investment ideas.  Active managers must add value by selecting attractive risk-adjusted investments without over diversifying investment portfolios."

Diworseification_GrizzlyRock.pdf

[Guest deepValue]

How do you have 22 'best ideas?'

[Uccmal]

How do you have 22 'best ideas?'

 

Giant Brain?

[blainehodder]

Quant strategies. Magic formula etc.  They work, and usually require diversification.

[giofranchi]

Fellow Corner of BRK community members,

 

Although it is highly likely I'm preaching to the choir here on this board - just figured I would share the original, attached paper.

 

Here is the abstract: "Active investment managers overuse the concept of diversification in the name of safety.  Many active managers overdiversify their funds to reduce portfolio volatility, which in turn reduces the business risk of the active manager at the expense of clients’ return. This diworseification has a deleterious effect on portfolio performance as active managers become closet indexers with high fees.

 

Best idea fund managers realize exemplary investment performance results from security selection and effective position sizing. When hiring an active manager, investors should demand nothing less than skilled capital allocation to the managers’ best investment ideas.  Active managers must add value by selecting attractive risk-adjusted investments without over diversifying investment portfolios."

 

Thank you very much for posting this!

Happy to see you used my favorite quote from one of the truly great economists and investment brains of last century!!  :) Even though you left out the last sentence which, imo, is very important!  ;)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience is definitely limited and there are seldom more than two or three enterprises at any given time which I personally feel myself entitled to put full confidence." - John Maynard Keynes

[Kraven]

How do you have 22 'best ideas?'

 

Giant Brain?

 

Investment activities conducted in the greater Lake Wobegon metro area?

[Ross812]

Isn't hiring multiple best idea managers to "moderate the inevitable outperfomance and underperformance during individual time periods" essentially over diversification?

 

At 20 securities, the vast majority of idiosyncratic risk has been diversified out of the portfolio.

Why not pick one manger who holds 20 stocks, then allocate the rest to other asset classes ex. bonds, short funds, precious metals ect...

 

Are you implying investment managers' funds should ultimately be treated as operating companies themselves? Considering "best idea" funds as individual companies and choosing several would yield a similar portfolio, in theory, to Giofranchi's portfolio of superior owner operators. The two portfolios would both be run by superior managers, but allocating money to these "great managers" of mutual funds and hedge funds would ultimately just add an extra layer of middle men to the end investment.

 

It seems a company is always a more streamlined investment vehicle than a mutual fund or hedge fund. It really only makes sense to invest in a fund if you do not have the time and aptitude to invest your own money. Even at that point, how hard is it to pick 10 great owner operators (say- BRK.A, MKL, LUK, Fairfax, BAM, LMCA, Bidvest, XOM, Inbev, and DHR) set and forget your investment without paying the fees?

[GrizzlyRock]

Ross812 - Hiring multiple best idea managers is not overdiversification. The theory is as follows, would you rather have 5 managers with their 10 best ideas or one manager with 50 ideas?

 

The goal of hiring an active manager is to access the manager's alpha producing ability. Sourcing multiple streams of alpha is ideal especially when you begin working with large sums (as institutional managers do)

 

Implicit in the concept is the power of geometric compounding which is why 2-4 investments is sub optimal for more people (i.e. people who can't avoid blowups)

[writser]

Is this a scientific paper or a recommendation for your fund? Thin line .. :)

[Ross812]

Ross812 - Hiring multiple best idea managers is not overdiversification. The theory is as follows, would you rather have 5 managers with their 10 best ideas or one manager with 50 ideas?

 

The goal of hiring an active manager is to access the manager's alpha producing ability. Sourcing multiple streams of alpha is ideal especially when you begin working with large sums (as institutional managers do)

 

Implicit in the concept is the power of geometric compounding which is why 2-4 investments is sub optimal for more people (i.e. people who can't avoid blowups)

 

We agree that "best idea" managers are superior to closet indexers. I am asking how many funds should you buy before you diversify away your returns? If you buy Fairholme, Wintergreen, and Oakmark you are at 41 securities right there. Your paper suggested that idiosyncratic risk is diversified away at 20 securities so does it make sense to buy 41 securities?

 

You can make the argument that many of these "best idea" managers are too concentrated in one sector and should therefore constitute a smaller proportion of your overall portfolio. Should the fund be treated as a single security and should the Kelly formula be applied? At this point, is a fund really an efficient way to invest? Why not buy Berkshire/fairfax and avoid the management fees entirely?

 

Sourcing multiple streams of alpha is another way of saying diversifying. I think mutual funds are a good idea for the small investor to cut down on transaction costs on small share lots as transaction fees can far exceed the management fee charged on a small sum in a fund. I would immediately fire an institutional manager for "sourcing alpha" from fellow mutual funds or hedge funds. The offending manager is hitting their clients with double fees.       

[GrizzlyRock]

Ros812 - we are basically in agreement here.  The distinction comes if we are talking about an individual investing say $500,000 versus an institution such as a pension plan investing $10 billion.

 

For a small investor, one or two active best idea funds or one low-cost index fund is best. For the $10 billion institution this is impractical. Institutions desire to capture alpha across a variety of fund types and would be best served using best ideas managers in each asset class if they are selecting active managers.

 

writser - As mentioned in the preface, its a thought piece written by an investor for investors.  I built my firm using the the most probabilistic ex-ante methods to compound capital over time.

[Yours Truly]

The best fund would be a compilation of a couple of superinvestors on Corner of BRK (ericopoly, packard, parsad, txlaw, etc) :)

[jay21]

The best fund would be a compilation of a couple of superinvestors on Corner of BRK (ericopoly, packard, parsad, txlaw, etc) :)

 

From Eric alone the fund would be long 100% BAC

[Palantir]

Grizzly - is your fund a public fund or for qualified investors only?

[stahleyp]

Grizzly, if you don't mind sharing, what's your AUM?

[GrizzlyRock]

YoursTruly - not a bad idea whatsoever.  At one of my old funds we had a "paper portfolio" where each analyst and PM could pick just 2 positions.  It crushed the performance of our actual funds (although the "paper portfolio" wouldn't have fit our mandates exactly)

 

stahleyp and Palantir - I DM'd you responses.  Prefer to keep specific commentary out of the public sphere.

 

BTW - I'm an open book on ideas.  If anyone wants to chat idea offline or on the phone I'm game.