Why Good Managers Invest in Bad Stocks

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How many attractive stock ideas does Naomi, an institutional active equity fund manager, have at any one time?

“Oh, I think between 10 and 20,” she told me.

So, why did her fund hold so many more times that number of stocks?

“To round out the portfolio,” she said.

I have asked these same questions of many active equity managers and received similar responses each time. The implication, of course, is that these managers are drowning the superior performance potential of their best ideas in a sea of bad ones.

Why would they hobble their returns in this way? After all, no expert chef would serve up their signature dish with generic supermarket bread. Why do skilled stock pickers make such errors when constructing portfolios, and what can we do about it?

Are professional managers skilled stock pickers?

The consensus is “no,” they are not. On average, active equity funds fail to meet their benchmarks, which suggests that investors should avoid them in favor of low-cost index funds.

But what if managers like Naomi stuck to their 10 to 20 preferred stocks? Would their portfolios do better? Studies confirm that they would. In the most compelling of these, “Best Ideas,” Miguel Anton, Randolph B. Cohen, and Christopher Polk find that the performance of the top 10 stocks held by active equity mutual funds, as measured by portfolio weights relative to index weights, significantly exceeded their benchmarks. As the relative weights decline, however, performance faded and at some point, probably around the 20th stock, fell below the benchmark.

Professional managers are superior stock pickers – if they stick with their 10 to 20 best ideas. But most mutual fund portfolios hold many more bad ideas than best-idea stocks.