The ability of fund managers to reliably generate market-beating returns is limited to three to five stocks.

These are the conclusions of Harvard Business School senior lecturer Randy Cohen, who has been conducting a study into the performance of fund managers’ ‘best ideas’ over the last 15 years.

‘What you see when you look at the data is that after fund managers’ third, fourth or fifth best idea, everything starts to look pretty much like the market performance,’ says Cohen.

‘These folks are putting about 100 stocks in a portfolio and only a few are creating outperformance.’

Cohen, along with colleagues Christopher Polk of the London School of Economics and Miguel Antón of the University of Navarra, IESE Business School, originally published their Best Ideas paper in 2009 and have been updating it ever since. During that time, as well as extending their original dataset on the historical holdings of US mutual funds from 1983 to the end of 2018, they have added a further dataset on hedge funds.

The headlines from the study are that the best ideas have generated statistically and economically significant risk-adjusted returns and systematically outperformed the other positions in managers’ portfolios. The findings are consistent across different benchmarks, different risk models, and different definitions of what constitutes a best idea. And while the level of outperformance varies depending on different assessment methods, it primarily falls in the range of 2.8-4.5% a year.

There have been other studies since the original Best Ideas paper came out that appear to support the findings.

Get real!

If the studies by Cohen and others are correct, why don’t funds only invest in their best ideas?

The most prosaic reason for a lack of five-stock funds is that industry regulators would flip out at the sight of them. But even ignoring this most practical of problems, sooner or later, any fund manager that did crank up portfolio concentration to such a degree could expect to get the sack.

Even portfolios of the five best-performing stocks over the long term are highly likely to produce long-enough periods of gut-churning disappointment to ensure a rush to the exit. Past industry fads for concentrated ‘best ideas’ funds have ended badly.

What is more, restricting investments to a handful of stocks would reduce the ability to build a fund business of reasonable scale due to the limits it would put on liquidity.

‘From a fund manager’s perspective, it is not good business to be concentrated,’ says Cohen. He sketches a somewhat radical alternative solution.

‘Imagine we divide the world into 10 regions and then into 10 broad industries. Now you have a grid with 100 boxes. Let’s say you found managers that would give you a bespoke five-stock portfolio for each of those areas. Now you have a 500-stock portfolio. So, you are very diversified, but you have not just captured the whole market. In each part you own an ultra-concentrated portfolio picked by an expert.

‘Institutional investors should say to managers: “Give me your five best ideas”. The manager says: “How about 100?” and they compromise on 20 to 25 and a higher fee. Instead, what sometimes happens is the manager says: “I’ve got 100 names”, and the institutional investor says: “Could you make it 150?”’

Fix the Future conviction picks

Citywire Fix the Future has gathered data on the near-7,000 stocks held across the portfolios of the world’s top 5% of fund managers.

Hunting out these elite managers’ boldest and most career-defining bets has a gut appeal. To do this, and to help us home in on the most interesting stocks in our database, we’ve created elite-manager conviction scores for their holdings and a ranking system for our 7,000-or-so stocks based on collective conviction.

The aim is to provide Citywire readers with insights into the managers’ investment styles and processes, and the work of Cohen and others suggests our approach may also help identify the best investments of the world’s best investors.