If you were asked to choose between a fund manager who had the courage of his or her convictions and invested heavily in a few specific stocks, or one who preferred to invest smaller amounts in a larger number of stocks, which would you choose?
Instinctively, most investors would probably opt for the former. Faced with seemingly complex problems like navigating the global financial markets, people are more inclined to trust someone with strong opinions on where the best opportunities lie.
But is it true that fund managers who like making big bets — or, as they generally prefer to put it, have “large active weights” or “high-conviction holdings” — produce better returns than managers who tend to spread their risk?
The research team at Morningstar recently studied this issue in depth and its findings are illuminating. (1)
The researchers analysed around 2,400 “big bets” across more than 670 U.S.-focused, actively managed funds from the start of 1997 to the end of June 2023.
They defined a big bet as any stock holding that averaged 5% of assets over its holding period and at some point accounted for 8% of portfolio assets and a 5% active bet against its category's Morningstar Index.
To measure how effective these big bets were, they compiled the total position histories for each bet and benchmarked stock and fund performance to their Morningstar Indexes.
Here are some of their findings:
1. Big bets are increasingly common
The first finding is that, although most fund managers do not make big bets, large holdings are becoming increasingly common. At the start of 1997, fewer than 3% of active funds held a big bet in their portfolios. However, by June 2023, that number had jumped more than fourfold to around 14%.
What drove that increase? Primarily, says Morningstar, it was down to the so-called “Magnificent Seven” mega stocks — Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla, which are commonly recognised for their market dominance and their impact on consumer behaviour and economic trends. (2)
2. Success rates differ across categories
The good news is that mutual fund managers often bet on the right stocks. About 60% of the bets analysed outperformed their portfolios’ relevant Morningstar Index during their holding periods.
However, bet success rates vary widely across different categories. Large-growth managers appear to be the best at making sizable bets, with more than 70% of their wagers outperforming the Morningstar U.S. Large-Mid Cap Broad Growth Index.
In contrast, only 37% of the major bets by small-blend managers were able to outperform the small-blend index.
3. Managers hold on to winners for too long
Something else the researchers found is that although managers may be reasonably good at identifying long-run winners, they are generally poor at recognising when a winner has peaked.
When position sizes peak, success rates, even for large cap-managers, are much less impressive. More concerning was that big losses became more frequent.
An example cited in the study is Sequoia Capital’s bet on Valeant Pharmaceuticals. Sequoia’s fund price benefited from a rise of 820% in the Valeant share price between 2010 and 2015. But the price tanked when Congress investigated the company for its pricing practices and the stock was eventually liquidated. In that time the fund dropped 25%, largely as a result of Valeant's demise. Morningstar’s U.S. Large-Mid Cap Broad Growth Index fell less than 1% over the same period.
4. Managers rarely bet on unproven companies
One of the main reasons given for using active funds is that, in theory, a good manager should be able to identify hidden gems — unproven companies with huge potential. They should also be able to spot possible turnaround stories — firms that are currently unloved but are about to get their act together. But Morningstar found that active managers are in fact far more likely to bet on companies that are already performing very well.
The stocks that managers were most likely to hold large positions in were the likes of Microsoft, Apple, and Alphabet. The problem, the researchers found, is that overweighting one of the mega stocks usually came at the expense of underweighting or not owning some or all of the others. Few funds in aggregate overweighted all of the mega stocks.
5. Getting a big bet right doesn’t ensure outperformance
Perhaps the most important question is whether big bets tend to translate into outperformance, and the answer, sadly, is no. While 61% of the bets Morningstar looked at outperformed the market over their holding periods, only 37% of the funds themselves beat the market over the same periods.
77% of the funds that beat their benchmark over a bet’s holding period would have outperformed the index in any case if the funds had never made the bets and instead reinvested that money in the rest of the fund.
In short, big bets don’t make nearly as much difference to a fund’s performance, either positively or negatively, as is often assumed.
6. Big bets barely affect your odds of success
A claim that’s often made is that using a high-conviction fund manager increases your odds of outperforming, but this study shows that it isn’t that simple.
It is true that bets seem to improve the odds of success in large-cap funds, but the bulk of funds with bets still underperform the market.
For small- and mid-cap funds, the success rate differences are consistently below zero, which indicates that the funds with big bets outperform less frequently than those without them. Some categories, like small value, have few big bets, so results can fluctuate wildly from one period to another.
7. Success is generally not repeatable
It is well documented that retail investors who make big bets are more likely to take similar risks in the future, regardless of whether their bets pay off. This study shows that the same is true for professional fund managers.
The researchers also found that early success appears to lull managers into getting too comfortable with the risks of betting big, with success rates diminishing over time.
Among the very first bets made in each portfolio, roughly one in 20 lost 50% or more. By the managers’ fifth bet, the blowup risk nearly doubled to almost one in ten.
The takeaway for investors
What, then, can investors learn from this Morningstar study?
Jack Shannon, the senior analyst who led the research, said in a recent interview that the key takeaway is that there are no easy shortcuts to good returns.
“A lot of (people) think there’s this shortcut that you can take,” he said. “(They think) there’s this cabal of insiders who know all the secret stock tips. And I’ll be able to bet it all on there and get my financial freedom.”
“But I think this shows that even among professional money managers, good investing is often done through a very boring approach. You can’t count on trying to make one big bet to drive an outcome. It’s just not something that is easily repeatable or even leads to any sort of long-term success.”
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.