Does the Number of Stocks in a Portfolio Influence Performance?

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1 Investment Insights January 2015 Does the Number of Stocks in a Portfolio Influence Performance? Executive summary Many investors believe actively managed equity portfolios that hold a low number of stocks are more likely to beat a passive benchmark. Their contention: portfolios with fewer stocks better represent a manager s best ideas, making these portfolios a more effective investment option after factoring in the cost of an active manager. Our analysis of actual U.S. large-cap equity mutual fund performance during the past 20 years shows there is no statistical evidence to indicate that there is a meaningful relationship between the number of holdings in a portfolio and its performance relative to a passive benchmark. Equity portfolios can successfully generate excess returns regardless of holdings count. Further, when we examined the rate at which equity portfolios of various holdings counts have outperformed their benchmarks, we discovered the results were similar: Funds with a low number of stocks and those with a high number of stocks historically have beaten their benchmarks with similar frequencies of success. Looking at the performance of Morningstar s U.S. large-cap equity blend category based on excess returns, our analysis showed that funds with fewer holdings performed slightly better than funds with more holdings during the 20-year period, but with significantly more volatility and downside risk. This moderate excess return advantage for funds with a lower number of stocks over the two-decade span was largely driven by outsized gains achieved during the late 1990s and early 2000s. Importantly, this performance advantage evaporated when we analyzed excess returns on a risk-adjusted basis (i.e., the return achieved for a given level of risk), as funds with the fewest stocks and those with the highest number of stocks provided similar results to investors. When choosing an active equity portfolio manager, investors may want to consider other well documented factors in their decision making, such as a portfolio manager s experience, skill, investment process, and access to research resources. All of these factors can be instrumental in assessing whether a portfolio is suitable in helping investors meet their overall investment objectives. Digging deeper: The relationship between portfolio holdings and performance Our analysis begins with a study of actual equity mutual fund data during the past 20 years (excluding index and enhanced index funds), using a variety of metrics to gauge whether holdings count is a valid characteristic to help investors identify equity portfolios to help meet their investment objectives. For our empirical analysis, we used the Morningstar U.S. large-cap blend universe of equity mutual funds as a proxy for actual portfolio manager performance and holdings counts. We sorted this universe of funds into quartiles based on holdings count, and compared the average number of holdings in each quartile over time with the average number of holdings in September 2014 (see Exhibit 1, page 2). This categorization provides a view of the average number of holdings of this stock universe in each quartile. KEY TAKEAWAYS Historical evidence indicates there is no meaningful relationship between the number of stocks in an actively managed portfolio and its performance. Equity portfolios with a lower number of holdings historically have had slightly better excess returns than portfolios with a higher number of holdings, but those relatively higher returns were driven largely by a single period of outsized performance during the late 1990s/early 2000s. Equity portfolios with either higher or lower holdings counts have beaten their benchmarks with the same success rates over time, and with similar risk-adjusted excess returns. Rather than the number of holdings, investors should focus on other factors when investing in an equity portfolio, such as a manager s experience, skill, investment process, and research resources. Authors Michael Hickey, CFA Institutional Portfolio Manager, Equities Christopher Luongo, CFA Institutional Portfolio Manager, Equities Darby Nielson, CFA Managing Director of Research, Equities Zhitong Zhang, CFA Quantitative Analyst, Equities This document has been provided by Pyramis Global Advisors. Pyramis is a subadvisor of institutional investment products to Fidelity Worldwide Investment. 1

2 Holdings count is often linked to portfolio concentration by many investors; the lower a portfolio s holdings count, the more concentrated the portfolio is likely to be in its top holdings. This being the case, we wanted to explore the relationship between holdings count and concentration. Funds with a high percentage of assets in the top 10 holdings are typically viewed as being more concentrated. When looking at the average level of top-10 holdings among our U.S. large-cap equity universe, after grouping into holdings count quartiles, funds with fewer holdings have been more highly concentrated than those with more holdings (see Exhibit 2, below right). However, even funds in our highest holdings-count quartile have maintained a fairly high level of concentration (almost 25% concentrated in their top 10 stocks), indicating that managers in this cohort can express conviction despite holding many names. Assessing performance: No clear distinction based on holdings count Our analysis of the performance of actively managed U.S. large-cap equity funds during the past 20 years shows that portfolios with fewer holdings have had moderately higher excess returns, on average, than funds with more holdings (see Exhibit 3 left, page 3). Our analysis also shows that the relationship between holdings count and performance is not consistent over time. In the most recent three-year period ( ), funds in the highest holdings-count quartile actually outperformed funds in lower holdings-count quartiles, on average (see Exhibit 3 right, page 3). Notably, when we looked at actively managed U.S. small-cap equity mutual funds, the results were very similar among funds in the highest and lowest holdingscount quartiles (see Appendix, page 7). Looking at the performance of our fund quartiles over time shows that funds with fewer holdings achieved a significant boost in returns during the late 1990s/early 2000s period (see Exhibit 4, page 3). It is also interesting to note that since the financial crises, funds with more holdings have outperformed funds with fewer holdings. These multiyear trends suggest that there is some cyclicality to the relationship between holdings count and fund returns, and that these may be due to changes in market conditions. Another way to evaluate whether portfolio holdings counts have influenced the historical performance of U.S. large-cap equity funds is to use regression analysis, a statistical measure that determines the strength of the relationship between a variable (holdings count) and an outcome (performance). We conducted a regression of excess returns on holdings count for our large Exhibit 1: Grouping the Morningstar U.S. large-cap blend universe in quartiles based on holdings count provides a view of the average number of holdings held by equity mutual funds. CURRENT AND HISTORICAL AVERAGE HOLDINGS COUNTS FOR U.S. LARGE-CAP EQUITY FUNDS ( ) Exhibit 2: Historically, U.S. large-cap equity portfolios with fewer holdings have a higher percentage of assets in their top 10 holdings than those with a larger number of holdings, but even the quartile with the largest number of holdings has a reasonably high level of concentration. AVERAGE TOP-10 STOCK CONCENTRATION FOR U.S. LARGE-CAP EQUITY MUTUAL FUNDS BASED ON HOLDINGS COUNT ( ) All equity mutual funds in Morningstar s U.S. large-cap blend category were grouped into (absolute) holdings count quartiles in each period, and average holdings counts were calculated on an equal-weighted basis for each quartile. Results from each period were aggregated to show historical averages. Historical holdings count data from 31 Dec to 30 Sep Current holdings count data as of 30 Sep Source: Morningstar, Fidelity Investments, as of 30 Sep Equity funds were grouped into holdings-count quartiles in each period, and average concentrations were calculated for each quartile. Results from each period were aggregated to show historical averages. Holdings counts are on all equity mutual funds in Morningstar s U.S. large-cap blend category from 31 Dec to 30 Sep Source: Morningstar, Fidelity Investments, as of 30 Sep

3 Exhibit 3: Equity funds with fewer holdings historically have generated slightly higher excess returns on average than funds with more holdings (left), but during the past three years, funds with more holdings have had relatively better excess returns (right). ANNUALISED THREE-YEAR EXCESS RETURNS FOR U.S. LARGE-CAP EQUITY MUTUAL FUNDS, GROUPED BY HOLDINGS COUNT ( ) Past performance is no guarantee of future results. Analyses use three-year, forward-looking, annualized, benchmark-relative gross returns. Gross excess returns were collected for each period, for each holdings-count quartile. Gross excess returns and holdings counts on all equity mutual funds in Morningstar s U.S. large-cap blend category. Data from 31 Dec to 30 Sep Source: Morningstar, Fidelity Investments, as of 30 Sep cap fund universe, using three-year returns from the December 1994 to September 2014 period. Our analysis indicated that there was generally no statistical significance to the historical relationship between holdings count and performance. For most of the period, funds with fewer holdings outperformed funds with more holdings. However, there also were extended periods of time during which funds with more holdings outperformed. Furthermore, the relatively small number of periods when the relative performance of one category handily outperformed the other (i.e., performance went past the threshold of statistical significance) suggests that the relationship between holdings count and performance is not robust (see Exhibit 5, page 4). Exhibit 4: During the late 1990s/early 2000s, funds with the lowest number of holdings had significantly better excess returns, on average, than funds with the highest number of holdings. THREE-YEAR ROLLING EXCESS RETURNS FOR U.S. LARGE-CAP EQUITY MUTUAL FUNDS BASED ON HOLDINGS COUNT ( ) We also examined the rates at which funds in each holdings count quartile outperformed their benchmarks over time essentially the batting average of each quartile. The results indicate that batting averages across the quartiles have been very similar, especially when looking at the smallest (55.1%) and largest (55.2%) quartiles (see Exhibit 6, page 4). This similarity suggests that holdings count has had little influence in a fund s success rate, and that the historical outperformance of funds with fewer holdings shown in Exhibit 3 left was skewed by the outsized returns of a few outliers in certain periods. Performance consistency: Measuring top and bottom quartile performance of equity funds Another way to examine the relationship between holdings count and performance consistency is to track how often Past performance is no guarantee of future results. Equity funds were grouped into holdings-count quartiles in each period, and average concentrations were calculated for each quartile. Results from each period were aggregated to show historical averages. Holdings counts on all equity mutual funds in Morningstar s U.S. large-cap blend category from 31 Dec to 30 Sep Source: Morningstar, Fidelity Investments, as of 30 Sep

4 Exhibit 5: Regression analysis indicates that the relationship between holdings count and performance is not statistically significant, most of the time. REGRESSION OF EXCESS RETURNS BASED ON HOLDINGS COUNT: U.S. LARGE-CAP EQUITY MUTUAL FUNDS funds in each holdings count quartile appear in the upper return echelon of all funds in the category. To this end, we examined how often actively managed U.S. large-cap equity funds in each holdings-count quartile performed within the top 25% (or the bottom 25%) of all funds from 1994 to 2014 (using threeyear excess returns to determine cut-offs). Our analysis showed that funds with fewer holdings were more likely to appear in both the top and bottom return quartiles than funds with more holdings, indicating once again that funds with fewer holdings generally have been more volatile (see Exhibit 7, page 5). In addition, when looking at the most recent set of threeyear returns (Sep Sep. 2014), a higher percentage of funds within the largest holdings-count quartile have been among the top performers, and a lower percentage of funds in this cohort have been in the lowest return quartile. Risk-adjusted performance: Little distinction based on holdings count For many investors, minimizing performance volatility can be a significant objective. To assess the performance consistency of actively managed equity portfolios over our extended period of study ( ), we calculated the information ratio (IR) of all four holdings-count quartiles of U.S. large-cap blend equity funds. The information ratio is a metric that measures a portfolio manager s ability to generate excess returns relative to a benchmark, while providing some insight on the volatility of those excess returns. For example, has a manager consistently outperformed its benchmark by a moderate amount over many Exhibit 6: Actively managed U.S. large-cap equity portfolios with higher and lower holdings counts have produced very similar rates of outperformance relative to their benchmarks over time. PERCENTAGE OF PERIODS WITH POSITIVE THREE- YEAR EXCESS RETURNS FOR U.S. LARGE-CAP EQUITY FUNDS BASED ON HOLDINGS COUNT ( ) Analyses use three-year, forward-looking, annualised, benchmarkrelative gross returns. Gross excess returns were collected for each period, for each holdings-count quartile. Gross excess returns and holdings counts on all equity mutual funds in Morningstar s U.S. large-cap blend category. Data from 31 Dec to 30 Sep Source: Morningstar, Fidelity Investments, as of 30 Sep Rates of gross excess returns (i.e., batting average) are measured as the average percentage of funds that outperform the benchmark over time for each holdings count quartile. Gross excess returns and holdings counts on all equity mutual funds in Morningstar s U.S. large-cap blend category. Data from 31 Dec to 30 Sep Source: Morningstar Direct, as of 30 Sep

5 Exhibit 7: U.S. large-cap stock mutual funds with lower holdings counts historically have had a higher rate of generating both top and bottom quartile excess returns. PERCENTAGE OF U.S. LARGE-CAP EQUITY MUTUAL FUNDS IN TOP AND BOTTOM PERFORMANCE QUARTILES BASED ON HOLDINGS COUNT ( ) Past performance is no guarantee of future results. Consistency is measured as the percentage of times funds in any holdings-count quartile show up in either the top or bottom gross returns-quartile for all funds. The above chart shows the across-time-average consistency for funds in all four holdings-count quartiles. Gross excess returns and holdings counts on all equity mutual funds in Morningstar s U.S. large-cap blend category from 31 Dec to 30 Sep Source: Morningstar, Fidelity Investments, as of 30 Sep months, or has the manager generated significant excess returns in only a few months? A higher IR indicates a manager has produced better returns for the same level of risk in other words, a portfolio has achieved higher excess returns with more consistency. Our results show that funds with the highest and lowest holdings counts historically have had very similar information ratios, on average (see Exhibit 8 left, below). Looking at a time series comparison of each quartile, it appears that market conditions have influenced the magnitude of excess returns. During the late 1990s and early 2000s, equity funds with fewer holdings had higher risk-adjusted excess returns (IRs) than those with the highest number of holdings. At the same time, during the past three years, funds with higher holdings counts have fared relatively better on a risk-adjusted basis (Exhibit 8 right, below). Similar patterns of risk-adjusted returns exist among actively managed U.S. small-cap equity funds (see Appendix, page 7). Exhibit 8: Historically, the risk-adjusted excess returns of equity mutual funds categorized with higher and lower holdings have been very similar (left). During the late 1990s/early 2000s, actively managed U.S. large-cap equity funds with fewer holdings had higher risk-adjusted returns than those with a high number of holdings, but the relative performance between the two groups has reversed since the financial crisis. AVERAGE THREE-YEAR RISK-ADJUSTED EXCESS RETURN FOR U.S. LARGE-CAP EQUITY MUTUAL FUNDS BASED ON HOLDINGS COUNT ( ) Analyses use three-year forward-looking, annualized, benchmark-relative gross returns and three-year tracking errors. Information ratios were calculated in each period for each fund using its return and tracking error, then aggregated by holdings-count quartiles. Information ratios and holdings counts on all equity mutual funds in Morningstar s U.S. large-cap blend category from 31 Dec to 30 Sep Information ratio: the return of a portfolio minus the return of a benchmark index divided by tracking error (the standard deviation of the difference between the returns of the portfolio and the returns of the index). Standard deviation (a measure of historical volatility): the dispersion of returns from its mean (square root of variance). Low standard deviation indicates returns tend to be close to the historical average (lower volatility); higher standard deviation indicates a wider range of returns relative to the average (higher volatility). Source: Morningstar, Fidelity Investments, as of 30 Sep

6 Exhibit 9: Funds with fewer holdings historically have been more likely to experience more extreme excess returns on both the upside and downside. BEST- AND WORST-CASE HISTORICAL EXCESS RETURN SCENARIOS FOR U.S. LARGE-CAP EQUITY MUTUAL FUNDS BASED ON HOLDINGS COUNT ( ) Past performance is no guarantee of future results. Worst-case scenarios are calculated as the 5th percentile lowest returns for each holdings-count quartile, while best-case scenarios are calculated as the 5th percentile highest returns for each holdings-count quartile. Averages are the mean gross excess returns for each holdings count quartile. Analyses use three-year, forward-looking, annualized, benchmark-relative gross returns. Gross returns were collected for each period, for each holdings-count quartile. Gross excess returns and holdings counts on all mutual funds in Morningstar s U.S. large-cap blend category. Data from 31 Dec to 30 Sep Source: Morningstar, Fidelity Investments, as of 30 Sep Downside risk: Performance of funds with fewer holdings has been more extreme Many investors, including preretirees or those in retirement on a fixed income, may be more concerned about downside risk than investors with longer-term horizons. When we analysed the historical returns for U.S. large-cap equity funds grouped by holdings-count, funds in the lower holdings-count quartile had a greater magnitude of excess returns on both the upside and downside, while the returns of those with higher holdingscounts tended to be less extreme (see Exhibit 9, above). Investment implications: There is no right or wrong number of holdings in a stock portfolio Although there is a commonly held view among many investors that actively managed equity portfolios with a smaller number of holdings are more likely to deliver superior returns because they offer exposure to a manager s best ideas, our analysis suggests otherwise. Equity portfolios can successfully generate excess returns regardless of holdings count, and there is no statistical evidence to indicate that there is a meaningful relationship between the number of holdings in a portfolio and its performance. Rather, when choosing an active equity portfolio manager, investors who place a strong emphasis on a portfolio s number of holdings may want to consider other factors in their decision making, such as a portfolio manager s experience, skill, investment process, and research resources. These factors can be instrumental in assessing whether an equity portfolio is suitable in helping investors meet their overall investment objectives. 6

7 Appendix Exhibit 10: U.S. small-cap equity funds with fewer holdings historically have produced slightly better excess returns than those with more holdings, and have been more likely to experience more extreme excess returns, both on the upside and downside. ANNUALISED THREE-YEAR EXCESS RETURN, WORST-CASE AND BEST-CASE HISTORICAL EXCESS RETURN SCENARIOS FOR U.S. SMALL-CAP EQUITY MUTUAL FUNDS GROUPED BY HOLDINGS COUNT ( ) Past performance is no guarantee of future results. Analyses use three-year, forward-looking, annualized, benchmark-relative gross returns. Gross excess returns were collected for each period, for each holdings-count quartile. Gross excess returns and holdings counts on all equity mutual funds in Morningstar s U.S. small-cap blend category. Data from 31 Dec. 1994, to 30 Sep Worst-case scenarios are calculated as the 5th percentile lowest returns for each holdings-count quartile, while best-case scenarios are calculated as the 5th percentile highest returns for each holdings-count quartile. Averages are the mean gross returns for each holdings count quartile. Analyses use three-year, forward-looking, annualized, benchmark-relative gross returns. Gross returns were collected for each period, for each holdings-count quartile. Source: Morningstar, Fidelity Investments, as of 30 Sep EXHIBIT 11: Historically, the risk-adjusted excess returns of U.S. small-cap equity mutual funds categorized with higher and lower holdings have been similar. AVERAGE THREE-YEAR RISK-ADJUSTED EXCESS RETURN FOR U.S. SMALL-CAP EQUITY MUTUAL FUNDS BASED ON HOLDINGS COUNT ( ) Analyses use three-year forward-looking, annualized, benchmark-relative gross returns and three-year tracking errors. Information ratios were calculated in each period for each fund using its return and tracking error, then aggregated by holdings-count quartiles. Information ratios and holdings counts on all equity mutual funds in Morningstar s U.S. small-cap blend category from Dec. 31, 1994,to Sep. 30, Information ratio: the return of a portfolio minus the return of a benchmark index divided by tracking error (the standard deviation of the difference between the returns of the portfolio and the returns of the index). Standard deviation (a measure of historical volatility): the dispersion of returns from its mean (square root of variance). Low standard deviation indicates returns tend to be close to the historical average (lower volatility); higher standard deviation indicates a wider range of returns relative to the average (higher volatility). Source: Morningstar, Fidelity Investments, as of Sep. 30,

8 Authors Michael Hickey, CFA Institutional Portfolio Manager, Equities Michael Hickey is an institutional portfolio manager. He is responsible for aligning the investment objectives and asset management opportunities within the intermediary and institutional investment marketplace with the ongoing management, innovation, development, and delivery of equity investment solutions provided by the U.S. equity division. Darby Nielson, CFA Managing Director of Research, Equities Darby Nielson has been managing director of quantitative research in the equity division since He manages a team of analysts conducting quantitative research in alpha generation and portfolio construction to enhance investment decisions impacting Fidelity Investments equity strategies. Mr. Nielson joined in 2007 as a quantitative analyst. Christopher Luongo, CFA Institutional Portfolio Manager, Equities Christopher Luongo is an institutional portfolio manager. He is responsible for aligning the investment objectives and asset management opportunities within the intermediary and institutional investment marketplace with the ongoing management, innovation, development, and delivery of equity investment solutions provided by the U.S. equity division. Zhitong Zhang, CFA Quantitative Analyst, Equities Zhitong Zhang is a quantitative analyst for the equity division and works on the core quantitative research team. She joined in August 2014, after obtaining her MBA from the Wharton School. Thought Leadership Vice President and Associate Editor, Kevin Lavelle provided editorial direction. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity Investments does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Past performance is no guarantee of future results. All indices are unmanaged, and the performance of the indices includes the reinvestment of dividends and interest income, and is not illustrative of any particular investment. An investment cannot be made in an index. Diversification/asset allocation does not ensure a profit or guarantee against a loss. Investing involves risk, including risk of loss. Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The securities of smaller, less well-known companies can be more volatile than those of larger companies. Definitions Excess return: the amount by which a portfolio s performance exceeded the benchmark, gross of fees, in percentage points. Tracking error: the standard deviation of the difference between a portfolio s performance and that of its benchmark. Information coefficient: a measure of the correlation between predicted and actual returns; a positive number indicates skill in prediction, a negative number indicates lack of skill, and a measurement of zero indicates no correlation between prediction and actual events. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. Important Information Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Index or benchmark performance presented in this document do not reflect the deduction of advisory fees, transaction charges, and other expenses, which would reduce performance. Certain data and other information in this research paper were supplied by outside sources and are believed to be reliable as of the date presented. However, Pyramis has not verified and cannot verify the accuracy of such information. The information contained herein is subject to change without notice. Pyramis does not provide legal or tax advice, and you are encouraged to consult your own lawyer, accountant, or other advisor before making any financial decision. These materials contain statements that are forward-looking statements, which are based upon certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different than those presented. Information ratio: portfolio excess return divided by the volatility of those returns (i.e., tracking error); a higher IR corresponds to higher excess return per unit of risk. 8

9 Important Information This material is intended for investment professionals and must not be relied upon by private investors. Fidelity Worldwide Investment refers to the group of companies which form the global investment management organisation that provides information on products and services in designated jurisdictions outside of North America. Fidelity Worldwide Investment does not offer investment advice based on individual circumstances. Any service, security, investment, fund or product mentioned or outlined in this document may not be suitable for you and may not be available in your jurisdiction. It is your responsibility to ensure that any service, security, investment, fund or product outlined is available in your jurisdiction before any approach is made to Fidelity Worldwide Investment. This document may not be reproduced or circulated without prior permission and must not be passed to private investors. Past performance is not a reliable indicator of future results. Unless otherwise stated all products are provided by Fidelity Worldwide Investment, and all views expressed are those of Fidelity Worldwide Investment. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and currency F symbol are trademarks of FIL Limited. Fidelity Investments is a privately-owned financial services firm based in Boston, Massachusetts, USA. Fidelity Investments established Pyramis Global Advisors (Pyramis) in 2005 as a separate business unit to focus on institutional clients. Pyramis investment team was initially formed through the migration of investment professionals from Fidelity Management & Research Company (FMR Co.), the mutual fund division of Fidelity Investments. Fidelity Worldwide Investment has agreed to be responsible for the distribution of Pyramis Global Advisors (PGA) products outside of North America. Issued by FIL Pensions Management (FCA registered number ) a firm authorised and regulated by the Financial Conduct Authority. FIL Pensions Management is a member of the Fidelity Worldwide Investment group of companies and is registered in England and Wales under t he company number The registered office of the company is Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ, United Kingdom. Fidelity Worldwide Investment s VAT identification number is Issuer in Germany: Issued in Germany by FIL Investments International - Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ. Issuer for Austria, Hungary, Slovakia and Czech Republic: FIL (Luxembourg) S.A., 2a rue Borschette, 1021 Luxembourg. Investments in smaller markets or which target specific industries can be more volatile than investments in larger markets or those with more diversified portfolios. EMEA