Portfolio concentration works - those who concentrate are rewarded

Diversification is called the only free lunch in finance. Any investor is constantly reminded that diversification is the one thing you should always do, but what is the evidence that diversification works against an alternative? The alternative would be to concentrate, have a less diversified portfolio. Well, now we have some evidence across a broad set of investors.

A recent study looked at 10,771 institutional investors from 72 different countries to determine whether concentration leads to abnormal returns. See "Portfolio Concentration and Performance of Institutional Investors Worldwide". This is an interesting study that takes a novel approach to seeing if concentration by home country, foreign country, or industry will lead to abnormal returns versus a diversified portfolio. The devil is in the details of how these concentration measures are constructed, but the authors provide some good food for thought. The results are clear - concentration will lead to higher returns. 

Of course, this does not mean that everyone should go out and buy a concentrated portfolio. Concentration is a function of having a perceived information advantage. If you have skill or learn in one area, it is likely that you will be able to generate abnormal returns. Those who specialize in local markets may have an information advantage over others. This information advantage will cause concentrations which manifest in abnormal return. Concentration is driven by perceived advantage, but all concentration does not mean an advantage exists. This study, however, shows abnormal returns are present for a broad group of institutional investors.

This work does tell us is that diversification may not be a completely free lunch. There is some cost because there is the opportunity for higher returns from not concentrating.  Find good managers and allow for concentration.