You might expect specialist investment funds to have a different portfolio to other funds and to use their expertise to achieve higher returns. But you''d be wrong on both counts, according to research by Daniel Fricke, to be presented at the Royal Economic Society''s annual conference at the University of Bristol in April 2017.
The research examines the portfolios of US investment funds in 2003, and finds that while specialists hold fewer different shares, the profiles of their holdings are not much different to that of mutual funds. While most fund portfolios have a large overlap, meaning that they will generate similar returns, this turns out to be similar to the investment performance of so-called ''specialist'' funds too.
The author comments: ''My findings are important for at least two reasons. First, they suggest that portfolio overlap is a simple explanation for why it is difficult to detect investors with superior performance. Second, given that specialists do not generate superior performance, it seems hard to justify why anyone should put their money in them.''
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Common asset holdings (or portfolio overlap) have received a lot of attention recently and it is well established that these can have an impact on price dynamics in real markets. In this paper, we explore a different aspect of portfolio overlap, namely its implications for investor performance.
The idea is simple: if two investors have similar portfolios (that is, many common asset holdings), they must have very similar performance. In other words, strong portfolio overlap could serve as a simple explanation for why it is very difficult to detect investors with superior performances.
To investigate this idea empirically, we mainly analyse investors with very concentrated investment portfolios (containing a small number of stocks): specialists. The main reason for focusing on these investors is that most existing theories posit that specialists should possess more accurate (superior) information relative to more diversified investors.
Hence, one would expect specialists to be ''special'' in the sense that first, they should occupy niches, investing in relatively exotic assets where few other investors are present; and second, they should show superior performances. We find that neither of these two predictions is true for the set of US mutual funds.
These results can be explained by taking a look at the structure of the typical holdings network. In Figure 1, rows correspond to individual funds, columns to stocks, and a link (black dot) is drawn between an investor and a stock if the fund holds that particular stock in its portfolio.
The holdings network shows a peculiar ''triangular'' structure: some mutual funds hold practically all stocks (closer to the top of the Figure), and others focus only on a relatively small subset of stocks (closer to the bottom of the Figure).
The same is true from the perspective of the stocks: some stocks are held by practically all funds (closer to the left of the Figure), and others are held only by a much smaller subset (closer to the right of the Figure).
The most interesting feature is that specialist funds do not hold specialist stocks: there are very few connections in the bottom right part of the Figure. Rather, specialists tend to hold those stocks that are held by most other funds as well. In other words, most mutual funds focus their economically meaningful investments on the same set of stocks. From this perspective, specialists are unlikely to be special.
This finding alone does not rule out the possibility that specialist investors have superior performance. In fact, it might be that they put more weight on those stocks that perform very well.
Therefore, we carefully test whether we can find significant differences in the performance of specialists relative to more diversified institutions. It turns out that, despite the fact that specialists tend to prefer stocks with certain characteristics (for example, younger and more liquid stocks), their performance is indistinguishable from that of highly diversified institutions. In other words, specialist investors are not very special.
These findings are important for at least two reasons: first, they suggest that portfolio overlap is a simple explanation for why it is difficult to detect investors with superior performance. Second, given that specialists do not generate superior performance, it seems hard to justify why anyone should put their money in them.
