Originally Posted by sparkythewonderdog
Thanks, all, for your opinions on the "active/index diversification" question. The potential for bloated funds to become closet index funds (albeit with higher expenses) seems worth keeping an eye on, and of course there have been some previous stellar examples of that problem. What I don't quite understand there is how the $1,000,000,000 stake (for %1 of the bloated fund, as saluki9 points out) compares with the total market capitalization and/or other relevant securities that would be available for purchase (and hence the number of potential buying oppotunities available for astute managers). It's clearly an enormous amount of money for me to comprehend, but if the market is large enough, then the approach of adding managers may indeed scale with the bloat. I guess we'll see on that count.
Here is how it applies. If you're going to one of the very very few successful active managers you have to find stocks that the market has somehow (despite the thousands of analysts) undervalued. On top of that, besides finding it (before any of the other managers find it) you actually have to buy it for your fund. Now, if the stock is really that great, you would want to load up on it right? Otherwise, what is the point of buying a stock thats 10,15, or 20%+ undervalued if you aren't going to buy enough of it to make a difference in your fund? I mean, who cares if your hot pick doubles if its only 0.5% of your portfolio?
Well, when you have a $100,000,000,000 fund, you have several big problems
1. You need $1,000,000,000 of a stock just to make up 1% of your fund
2. To accumulate enough of that stock without the entire world knowing about it you have to be buying pretty big stocks with large float.
3. Almost by default you have limited yourself to the securities which have THE MOST analyst coverage, making them the least likely to be undervalued.
This is why you can tell that most active managers don't really believe in active management. If they did their portfolios would be
1. Smaller in total size
2. Hold far fewer positions than most do.
I forgot the exact number, but the average active fund holds something like 200 stocks. Do you really think the fund manager can make a good case for 200 stocks? Of course not, but most managers are far more worried about negative tracking error than they are with positive tracking error. The truth is that most of the really good active managers (there are some) don't outperform every year. They need patient investors which is why so many of them have gone to hedge funds where they can force their investors to be patient by limiting the timing of distributions.