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Alternative Market Briefing

Other Voices: Concentration or diversification: which drives outperformance in actively managed strategies?

Wednesday, June 04, 2014

By: Alexander Hart, Senior Research Analyst, Federal Street Advisors

With broad equity markets performing exceptionally well over the last five years, there has been much debate over the benefits of active versus passive investment strategies. As strong proponents of fundamental investing, we have long believed that well-executed, actively managed strategies outperform passive index-based approaches over full market cycles. But within the active management camp, there remains significant discussion over how to best deliver that outperformance.

A centerpiece to that debate is the topic of concentration versus diversification. Many believe that concentrating your investment in a small number of stocks is necessary for outperformance, and diversification merely dilutes returns. While we agree that concentrated portfolios are one way to deliver outperformance, concentration is neither a requirement nor a predictor of good results.

We would argue instead that the real key to achieving outperformance is differentiation.

Applying logic to the question, one would conclude that in order for a portfolio to outperform an index it must be constructed with component parts that are different than the index. A portfolio of stocks similar to its benchmark will logically deliver similar returns, while a portfolio with different stocks is likely to deliver different returns. At Federal Street Advisors, we invest in managers that seek to generate high levels of......................

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