In order to improve performance, advocates of active management have begun to argue that managers should focus exclusively on their best ideas, holding more concentrated portfolios of securities in which they have the highest confidence. In contrast, we argue that if it becomes popular, such “high conviction” investing is likely to:
- Increase risk,
- Make manager skill harder to detect,
- Raise asset owners’ costs, and
- Reduce the number of outperforming funds.
These arguments apply even if we accept that security selection skill is prevalent among active managers. Concentration only makes sense if managers have a particular type of skill, and this skill must be intrinsically rare.
Most active managers fail most of the time, at least if we regard their underperformance of passive benchmarks as indicative of failure. This fact is so well known and widely demonstrated that even staunch advocates of active management acknowledge it.
What remains in dispute is what active managers should do to improve performance. Some argue that active management fails because it is not active enough. Active managers, it's said, are reluctant to deviate too much from a passive benchmark, knowing that their performance will be compared to it. They hold positions they don’t find especially attractive, simply to ensure they do not fall too far behind their peers. The proposed remedy for such “overdiversified” portfolios is for managers “to invest with high conviction, concentrating capital in the ideas they think are most likely to deliver strong long-term returns.”