Concentration Cautionary Tales

Concentration is a highly debated topic in modern portfolio management theory with investors still trying to decide between betting it all on the best ideas or creating a well-diversified basket of securities. Our previous paper, “Does More Diversification Result in Better Performance?” by Osmond Wang, argues that concentration can pay off handsomely when the top trades are successful but it can also amplify the risk of significant losses. This is especially true in times of market turmoil and high volatility, such as the second half of 2015.

Our previous paper also highlighted the negative relationship between very high concentration and performance. Excluding the managers with the highest concentration levels from the regression analysis changes the regression coefficient from negative to positive. Therefore, concentration should be taken in small doses because too much might damage the portfolio.

This article will supplement our earlier analysis with three examples of real-world highly concentrated portfolios that lead to losses for managers. The review will cover January 2014 through January 2016, and will focus on the managers’ performance, top securities, and the effect on the total contribution. Let’s get started.

About Our Data

Everything mentioned in this post is sourced exclusively from public data, including the manager’s profile, simulated performance and all other analysis and commentary. The data used here omits the short side, non-equity securities, many non-US securities and all non-public information such as actual fund performance. To simulate performance and determine portfolio attributes such as liquidity, we combine public holdings data with market and pricing data and make simple assumptions.

Hedge Fund Manager One

Controlling 1.1 billon in assets with nine positions, this manager is a supporter of the long-term fundamental investment theory. Therefore, it is not surprising to see the historically high concentration of their top 5 positions.

The manager’s cumulative return has underperformed both the S&P 500 and the MSCI World by 50% and 38% respectively.

Currently, the two main positions in the portfolio are Sears Holdings and Autonation Inc, accounting for almost 60% of the book.

Sears Holdings has experienced significant volatility, with its price dropping from $47.76 in March 2014 to $16.71 at present.

Autonation Inc exhibited better performance, with a price increase from $49 in January 2014 to a high of $64 in mid-2015. The trend continued until December 2015 when the security’s price started dropping sharply, and is currently at $48.

In terms of relative attribution, the book has not performed well. A shocking 88% of names in the portfolio underperformed their relative sector benchmark and 99% of capital was allocated to underperformers. Even with the majority of the book being underperformers, the negative Selection Alpha of the top two positions was the biggest cause of the negative contribution for the portfolio. Sears Holdings and Autonation detracted more than 3,400bps of alpha, almost 65% of the negative ~5,400 bps Total Security Selection alpha for the period.

Hedge Fund Manager Two

Manager Two has a market value of 82M, and currently invests in 5 securities. From Jan 2014 through June 2015, they significantly outperformed the market benchmarks. However, during the second half of 2015, there was a dramatic reversal. As of December 2015, the manager had underperformed both the S&P 500 and the MSCI World by 51% and 39% respectively.

This manager generally runs a concentrated book with a historically high exposure to the Information Technology sector.

Currently, ~90% of the portfolio is invested in three positions, Servicesource Int, Terraform Power Inc and SunEdison Inc.

However, the portfolio looked somewhat different as of June 2015, when SunEdison Inc represented 54% of the book.

SunEdison Inc has been volatile, with a sharp price drop during the second half of 2015; going from a high of $30 in June 2015, to a low of $1.43 currently.

The second biggest position in the book, Terraform Power Inc, suffered a similar fate. The security reached a peak of $40 in May 2015, followed by a sharp drop to its current prices of $8.

The portfolio has a total negative contribution of ~5,100bps for the period, fueled by the significant negative Selection Alpha detracted by these top two securities. Sunedison and Terraform Power detracted a combined ~7,000bps of alpha from the portfolio.

Hedge Fund Manager Three

Manager Three controls 470M in assets and invests in 13 securities. Since January 2014, they have significantly underperformed both the S&P 500 and the MSCI World by 42% and 30% respectively.

The top three positions in the book; Visteon Corp, Travelport Worldwide and Loral Space & Communications, currently represent ~50% of the portfolio.

Visteon Corp had a positive price trend during the majority of the period helping the fund’s performance and attribution. However, the security is showing a sharp price drop in the current month going from $115 at the end of December to $66 currently.

The negative price trend continues when looking at both Travelport Worldwide and Loral Space. Travelport has had a price decrease from $18 at the end of 2014 to $12 now.

Loral Space and Communications had a price decrease larger than 50%, going from $79 in early 2014 to $31 at present. During the same time period, the quantity increased from 1MM to above 2MM, which further fueled losses.

In terms of relative attribution, 43% of securities outperformed their sector benchmarks and 55% of capital was allocated to outperformers. Negative Security Selection Alpha is the main reason behind the negative Total Contribution for the time period, and was being fueled by two of the three top positions in the book; Loral Space and Travelport Worldwide.

Conclusion

Finding the ideal balance in a portfolio is a mix of art and science. A seasoned portfolio manager knows the formulas are important, but they can only take you so far. You need to trust in your instincts as well. Many managers have made the hall of fame for using this high concentration strategy successfully but, as we just reviewed, large bets can be very risky and damaging to the overall performance. Concentration is like salt; a little enhances taste, too much will give you a heart attack. At the end, the decision is left to the chef.

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