Concentration and diversification
Portfolio construction · Hedge Fund Manager Blueprint
Every portfolio lies on a continuum between a single position and the market index. The degree of concentration should be a deliberate decision rather than a consequence of the number of ideas available at a given time.
The case for concentration
The expected return of a manager's highest-conviction idea should exceed that of the tenth. Where a manager possesses genuine skill, dispersing capital across many positions dilutes the portfolio towards the index, while the fee structure continues to assume active value added.
Concentration also improves the quality of analysis. Twelve positions can each be researched thoroughly; sixty cannot. A portfolio of sixty positions that are incompletely understood may carry greater risk than a portfolio of twelve that are well understood, irrespective of measured volatility.
The case against concentration
Managers' estimates of their own skill are subject to overconfidence. Position-level hit rates among successful fundamental managers typically lie between 55% and 60%, implying that approximately four in ten high-conviction ideas will prove incorrect. Excessive concentration converts ordinary error into permanent impairment of capital.
Concentration also introduces behavioural risk. A 20% position that declines by 40% reduces fund value by 8% and places considerable pressure on the manager's judgement. Decisions taken under such pressure are generally of lower quality, and the pressure is greatest when sound judgement is most required.
Prevailing practice
Most fundamental managers hold between 15 and 30 positions, with the five largest representing 25% to 40% of the portfolio. This degree of concentration allows security selection to influence returns materially while ensuring that a single error does not threaten the fund.
Position sizes should be determined by downside risk rather than upside potential. At equal conviction, a position with an estimated downside of 15% may be held at approximately twice the weight of one with an estimated downside of 40%.
The role of correlation
A portfolio of twenty positions that depend on a single macroeconomic factor is, in economic terms, a single position. This is the most common form of concealed concentration, because it is not evident from a list of holdings and becomes apparent only during a drawdown.
Holdings should therefore be grouped by common failure mechanism rather than by sector classification. Exposure limits should be set at the level of each group, and individual position sizes derived from those limits.
Work this through
Take a portfolio of at least fifteen positions, whether actual, simulated or constructed for the exercise.
Group the positions by failure mechanism rather than by sector, identifying the single developments that would adversely affect several positions simultaneously. Calculate the portfolio's aggregate exposure to each mechanism.
For any mechanism representing more than 25% of the portfolio, describe the measures required to reduce the exposure and estimate their cost.
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