If you had conducted a straw poll of investors’ greatest fears going into 2025, I suspect concentration risk would have ranked near the top. The Magnificent Seven accounted for more than half of the 26% return from the S&P 500 last year, pushing concentration to extreme levels across global indices (though early signs of a reversal are emerging).
Given the column inches it’s commanded over the past year, it’s fair to say that the concentration risk of the US tech behemoths will come as little surprise to investors. But should investors be cautious of throwing out the baby with the bathwater in terms of dismissing concentration as a perennial negative?
The answer is quite possibly, given that concentration can be a powerful driver of returns under the right conditions (more of which in a moment). For active funds in particular, a carefully curated, high-conviction portfolio can be a potent source of alpha generation, freed from benchmark constraints.
This ‘deliberate’ concentration allows managers to undertake more in-depth research on a smaller number of companies, often with an element of active management, and focus on the fundamentals. It also avoids the issue of becoming a ‘closet index’ strategy but with higher fees than passive alternatives.
In a recent webinar, Craig Baker from Alliance Witan spoke about a high conviction and active share driving outperformance, while over-diversification can be a drag on returns. He highlighted that most funds generate their strongest returns from their top 10 or 20 highest conviction ideas, with neutral or negative returns from ‘filler’ stocks included for risk management purposes (rather than their return potential).
A high conviction approach clearly needs to be accompanied with the right ingredients to be a recipe for outperformance (rather than failure). Most importantly, it requires a proven and repeatable investment strategy to capture outsized returns through stock-picking. It’s also best suited to an investment horizon of three to five years to ride out short-term market rotations and the fertile hunting ground of a broad investment universe.
However, a high conviction approach can be a challenge for open-ended funds which can’t hold more than 10% in any one company (with a further limit around 5% holdings). The need to meet redemptions can also make it difficult for OEICs to invest in more illiquid markets, as well as taking a longer-term view.
As a result, the investment trust structure may be better suited to concentrated portfolios. One such example is Rockwood Strategic, a UK small-cap specialist managed by Richard Staveley. With a highly concentrated portfolio of around 20 holdings, Rockwood takes a private equity-style approach by working closely with management teams to unlock value for shareholders.
Given the relative illiquidity of the small-cap sector, Richard has an exit plan in mind when investing, with merger and acquisition activity typically serving as the most likely exit route. This high conviction approach has helped Rockwood achieve an impressive five-year share price return of 190%, topping the AIC UK Smaller Companies sector.
Another example is Alliance Witan, which offers investors a one-stop shop global fund with 11 managers asked to submit up to 20 of their best ideas. Alliance Witan manages risk by blending allocations at the top-level, ensuring that stocks are selected for their return potential rather than risk control.
With an active share of more than 70%, the trust has delivered a five-year share price return of almost 110% and sits at the top of the AIC Dividend Hero list, boasting 58 consecutive years of dividend increases.
While emerging markets may not seem an obvious destination for a concentrated strategy, Mobius seems to tick the box in terms of a proven investment strategy. The trust has a 20-30 strong portfolio sourced from emerging and frontier markets, with a particular focus on small and mid-caps.
Like Rockwood, the trust’s concentrated approach allows it to work closely with management teams to unlock operational improvements and drive a re-rating in valuation. The managers look for innovative businesses benefiting from long-term secular trends such as artificial intelligence, renewable energy and Asia’s rising consumer class.
Given the higher risk nature of emerging markets, the trust uses a macro risk overlay to provide downside protection, with extensive on-the-ground research providing an in-depth understanding of the dynamics of the wider economic and regulatory ecosystem. This approach has paid off, with Mobius achieving a five-year share price return of almost 80%.
It’s worth saying that a high conviction approach is dependent on the skill of the managers in uncovering hidden gems, together with the willingness to weather shorter-term volatility. However, managers can generate significant alpha by focusing on a portfolio of best ideas rather than managing risk through excessive diversification. As Warren Buffett aptly put it: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
Jo Groves is an investment specialist at Kepler Partners. The views expressed above should not be taken as investment advice. All numbers are as of 17 March 2025 unless stated otherwise.