Let me begin with the punch line – a paradox:
In investment management, it is possible to own many securities and be selective; possible to add securities and add value; and possible to get diversification for free.
How do we know?
We do it.
The UNIO ALL-SEASONS FUND currently owns 140 securities.
We are highly selective in choosing those securities and assigning them a particular weight in the portfolio.
The performance of quartiles of our portfolio validates the view that as we add securities we add value – or we would stop adding them.
Finally, since we add securities to add value (not, primarily, to diversify), we view the added diversification as costing our investors little to nothing. This is why we say added diversification is virtually free.
Some people have a tough time wrapping their heads around this idea – especially, if they’ve been used to hearing a different story.
They’ve heard that if you own more securities than the minimum necessary for diversification, you move toward being a closet indexer. Specifically, the conventional wisdom says:
being selective means owning the minimum number of securities consistent with minimally acceptable diversification
adding more securities beyond that minimum dilutes the power of the others
any extra diversification you get by adding securities beyond the minimum comes at a cost of significantly worse returns.
Our experience is that the conventional wisdom is not true all of the time. Our 140 securities could not be more consciously selected and more different than the 20 or so geographic indexes that we compare them to.
I explain our counter-intuitive view with the art gallery analogy:
If you have a gallery with 25 of the world’s greatest paintings, including a Rembrandt and a van Gogh, you have a great gallery with a lot of value.
But if you expand the gallery to include 125 of the world’s greatest paintings, you can add a lot of value and still be selective. You may have the Rembrandt as one of the top 25. It may be far more valuable than a Paul Klee you add as the 125th painting. But, depending on what price you add the Klee, over time the Klee may rise faster than the Rembrandt.
Assume you own a portfolio of paintings the way you own a portfolio of stocks. You put 5% into the Rembrandt; and 0.5% into the Klee. The Rembrandt appreciates 20% and adds 1% to the total value of the gallery (5% weighting times 20% = 1%). The Klee rises 100% and adds 1⁄2% to the total value of the gallery (0.5% weighting times 100% = 1⁄2%). The Rembrandt adds more dollar value to the gallery than the Klee (1% vs. 1⁄2%) but the Klee performs better (100% vs. 20%) and raises the total performance of the gallery.
The gallery effect works as long as: (1) there are plenty of paintings of value to pick from; (2) you pick them at prices that potentially can outperform the top 25 masterpieces; (3) the risk of underperformance, temporary or otherwise, is lessened by the smaller weight you assign to these new picks; and (4) the difference between the performance of the top 25 and the 125 is close enough that the whole portfolio is pulling its weight.
Substitute the word “stocks” for “paintings” and you have what we do at UNIO CAPITAL and with the UNIO ALL-SEASONS FUND. In portfolio management, selectivity and abundance really can work together!
— John A. Allison