Australian investors are streaming into passive exchange-traded funds, no doubt attracted by their low cost, accessibility and the fact that most active managers have failed to beat their benchmarks across multi-year periods.

Outperforming the bullish market of 2019 proved difficult for most managers. Only a quarter of active Australian equity large cap managers within the Morningstar coverage universe beat the index after fees, according to Morningstar's Annual Australian Equity Sector Wrap 2020.

Morningstar's director of personal finance Christine Benz says an all-index portfolio can be a cost-effective—and just plain effective—way to build a portfolio. That said, she says not every active fund automatically belongs on the cutting-room floor.

"Some managers have earned their keep over time by investing with conviction: believing in its stock pick enough to pack a lot of assets behind them, building cash rather than buying overpriced stocks, and eschewing the biggest names in the benchmark if they don't find them fundamentally attractive," she says. 

Morningstar analysts suggest coronavirus-induced market volatility may give the best active managers an opportunity to shine.

"History has shown us large market dislocations have been times when good active managers have proven their worth, the best of them delivering lower volatility and greater downside protection than the passive index funds," Morningstar senior analyst Ross Macmillan says.

Risky business

A highly concentrated style doesn't guarantee strong performance, and it may even add risk and volatility. When you own a basket of 100 different stocks and one goes belly-up, the effect is fairly limited – but if a company collapses and it accounts for 10 per cent of the portfolio, that could seriously hurt performance.

Morningstar direct of passive strategies, North America, Alex Bryan says concentrated funds also run the risk of missing out of top returning stocks by being focused on a few.

"Historically, a small minority of stocks have really driven most of the market's performance," he says.

"If you think about increasing concentration and owning fewer stocks or parking more of your assets in a smaller number of stocks, that actually increases the likelihood that you might miss out on the handful of the stocks that really drive the market's return.

"That opportunity cost of missing out on the market's big winners can offset the benefit of avoiding its many losers."

But some of the best investors—notably Warren Buffett—have used a concentrated approach to good effect, Benz points out. 

To help identify solid fund managers who do so, we used the Morningstar Fund Screener to look for Morningstar Medallist equity funds that maintain concentrated portfolios of fewer than 40 holdings.

Selection of Morningstar medallist concentrated equity funds

concentrated

Source: Morningstar Direct

Premium Members can view analysis of each fund; here's a closer look at two of the funds on the list.

Magellan High Conviction (19878)

Category: World large blend | Analyst rating: Silver

With just 10 holdings, and almost 90 per cent of its assets it the top 10 holdings, the Magellan High Conviction fund is the most concentrated fund on the list. The concentrated approach has certainly served the manager well so far. Since inception in 2013, the fund has delivered annualised returns of 14.65 per cent against a category average of 11.30 per cent. It has, however, stumbled amid the coronavirus market falls, returning -7.28 per cent this year and underperforming the category by -0.70 per cent.

Morningstar senior analyst Andrew Miles says the fund applies a judicious process to investing and boasts a talented team in co-founder Hamish Douglass and co-portfolio manager Chris Wheldon.

However, he warns investors should brace for higher volatility, and use this strategy as a limited component of a more broadly diversified portfolio.

"The portfolio declined more than the index in Q12020, which was disappointing," he says.

"While this period is short and unusually volatile, divergent performance from the index is expected in such a concentrated product, which is why we recommend investors use the strategy sparingly.

"This strategy, when used in a limited fashion, is a high-calibre option, but our preference lies with the less aggressive Magellan Global Fund.”

Magellan’s fundamental bottom-up approach seeks companies with sustainable competitive advantages that can grow more quickly than the overall economy.

The portfolio is ultraconcentrated, containing the eight to 12 highest conviction ideas. Historically, managers have tilted towards consumer-related and technology sectors. Top holdings include US technology giants Microsoft Corp, Facebook, Apple and Alphabet, alongside financial services giant Visa and healthcare firm HCA Healthcare.

Greencape High Conviction (14653)

Category: Australia large growth | Analyst rating: Gold

On the opporsite end of the list, the Gold-rated Greencap High Conviction is the least concentrated. It holds 39 equities and 45 per cent of assets are in the top 10 holdings.

Miles says that portfolio managers David Pace and Jonathan Koh rarely put more than 55 per cent of assets in the top 10 holdings and avoid undue sector bets by focusing on stock-specific opportunities rather than thematic plays.

Pace and Koh undertake detailed fundamental bottom-up research with a focus on companies’ business models and management. They also look at where a company sits in the supply chain, helping the team better understand its competitive position.

"Greencape pounds the pavement collecting information from competitors, suppliers, ex-employees, and other industry experts," Miles says.

"This work allows the firm to better understand the outlook for companies."

Long-term performance has been strong. The fund has outperformed the S&P/ASX 200 Index in nine out of the past 12 calendar years.

This year, the strategy has returned -11.98 per cent, beating the category by 3.22 per cent and the S&P/ASX 200 TR index by 4.36 per cent.

Top holdings include CSL Limited, BHP Group and three of the four major banks. Its increased holding in James Hardie Industries has been a standout over the last year, returning almost 50 per cent, alongside CSL, up 40.78 per cent.

“The strategy has navigated a wide range of market conditions extremely effectively and protected capital better than most during market slumps,” Miles says.

“Its risk-adjusted performance consequently stacks up very well.”