Portfolio Concentration Better than Diversification?

Traditional asset pricing theory implies that diversified portfolios are optimal and suggest investors do not take advantage of international diversification opportunities, but more recent studies argue that portfolios can be under-diversified but optimal if they are formed on information advantage, say researchers from the University of Wyoming, the University of Wisconsin-Madison and Brock University.

The researchers’ own study shows that concentrated investment strategies in international markets can be optimal. Their results suggest that investors rationally choose to overweight certain markets and industries because of information advantage from specialization and economies of scale.

Using data about security holdings of 10,771 institutional investors from 72 different countries, the researchers tested whether concentrated investment strategies resulted in superior abnormal returns. They measured three measures of portfolio concentration: home bias, foreign country concentration and industry concentration, and they used two measures of performance: overall portfolio performance and performance of the part of the portfolio invested in a target country.

Overall, the results indicate that portfolios more concentrated in a few countries and industries perform better than portfolios more diversified across countries and industries. The researchers say the result is particularly strong for portfolio concentration in foreign markets and industries. “These findings suggest that investors have some information advantage when forming concentrated portfolios, which results in better portfolio performance and risk-adjusted basis,” the researchers wrote in their paper.

While the sample in the study consisted of different types of institutional investors, mutual funds dominated the sample, so the researchers did their analysis separately for mutual funds. Results were the same, showing that portfolio concentration in country and industry is beneficial for the performance of mutual funds as well as other types of institutional investors.

The research report is here.