For the past few years, the passive-vs.-active debate has been characterized as a pitched battle between two sides. Upon closer inspection, however, some might recognize this ongoing argument is far more nuanced than it appears at first blush and actually involves multiple sides with somewhat vague allegiances.
In fact, among actively managed funds, two distinct camps have emerged: those that favor a concentrated portfolio and those that espouse a highly diversified approach.
On one side are the actively managed funds that show a bias for concentration, building portfolios of about 25 to 40 stocks that aim to optimize returns by capturing idiosyncratic, stock-specific alpha through superior selection. On the other are those that attempt to lower risk by constructing highly diversified portfolios of as many as 200 positions that largely track the indexes and attempt to add alpha on the margins.
Upon closer inspection, the diversification puzzle is far less black and white than many portray. In fact, an efficient frontier exists in which a portfolio can hold a meaningfully higher number of stocks than most concentrated portfolios (between 80 and 160), while also delivering idiosyncratic, stock-level alpha through investments in high-quality assets marked by sound fundamentals, positive business momentum and attractive valuations. When diversification is a byproduct of rigorous analysis and bold stock picking, it can yield similar returns as far more concentrated portfolios, with lower risk and reduced volatility.