New study flags risk in Dutch pensions’ concentrated stock strategy

Under strict sustainability guidelines and pressure from stakeholders to “know what they own” when investing, Dutch pension funds have developed an affinity for concentrated equity allocations in recent years. 

Some chose to have a concentrated carve-out that is actively managed, often with impact investing themes. But one prominent proponent, Huisarts & Pensioen, overhauled its entire equity allocation in 2024, which represents about a quarter of its €10 billion assets. It reduced its holdings from several thousand companies to 65 names in a radical pursuit of accountability and transparency to its members who are general practitioners in the Netherlands.  

But while a concentrated equity strategy makes ESG and reputation risks more manageable, a new study from the Rotterdam School of Management at Erasmus University flagged the diversification risk and higher volatility it introduces into the portfolio.  

Professor of Finance at the Rotterdam School of Management and co-author of the new study, Mathijs van Dijk, says the number of stocks needed to fully diversify a global portfolio today is around 750 – if the asset owner can tolerate a few extra basis points of volatility, then 100-250 stocks would do the trick. 

“If you have less than a few hundred stocks… then you’re running financial risks that at least you need to consider and be able to explain,” van Dijk tells Top1000funds.com. 

“Maybe they [the pension funds] want to accept the trade-off – it’s up to them, but I think it’s important to recognise that there might be a trade-off.” 

The research acknowledged that classical finance theory suggests owning 30-40 stocks is enough to fully diversify the idiosyncratic risks, per Meir Statman’s widely referenced 1987 paper, How Many Stocks Make a Diversified Portfolio?. But the paper itself is out of date and its subsequent derivative studies tend to have a US-focused stock sample. 

Ongoing debate 

The push towards a smaller equity portfolio has been an ongoing conversation in the Dutch pension industry in conjunction with political pressure on asset owners to invest more domestically.  

In a position paper published this month, Dutch investor group Eumedion – whose board members count Gerard Fehrenbach (senior advisor of responsible investment at PGGM) and Alfred Slager (investment committee chair at ABP) – said passive investing has watered down asset owners’ commitment and stewardship at their investee companies.  

It recommends that pension funds apply “more focus and concentration in the equity portfolio”, which could also benefit Dutch listed companies as asset owners would have larger stakes in them. This stability in the shareholder base would encourage companies to pursue longer-term goals.  

“Asset owners are also expected to act as stewards of their investee companies and to truly understand these companies. An overdiversified equity portfolio does not fit in with this,” the position paper states.  

Van Dijk says he also sees the case where a fund may want to adopt a concentrated portfolio for risk management purposes.  

“It’s a little bit harder to assess… [but] if you truly want to understand the risk of the company that you invested in – particularly the forward-looking climate related risk – like might there be stranded assets 10 years down the road – that’s probably going to be hard to do for 3000 stocks,” he says.  

“But there might be a trade-off also for having better risk assessment.” 

Huisarts & Pensioen declined to comment on the research findings when approached by Top1000funds.com but later issued a statement on its website. Despite worries that smaller portfolios have higher volatility, it said the difference is very small and within an acceptable range.  

The fund also brushed off suggestions that it is building too much concentration by only holding 65 stocks, saying that it limits its risk through sound stock-picking and not choosing companies randomly or based on size.  

“We do not want companies that focus on the riskier innovations, but rather companies that supply the crucial components for their realisation,” read the statement published in Dutch.  

“By compiling our own portfolio and not investing in all companies, the return in the short term may deviate from the broad stock market, both positively and negatively. Over the long term, this will balance out and we expect to achieve a comparable return.” 

FOMO risk 

While that might be the case, van Dijk says it’s still very hard to predict and invest in winning stocks as only 2 per cent of companies accounted for all stock market wealth creation or equity premium over his research’s 40-year sample period (1985-2023).  

Concentrated portfolios also run a higher risk of missing out on returns if they fail to select the very few winning companies dominating the markets – right now, those are the Magnificent 7. The research termed it the FOMO (fear of missing out) risk.  

“If you have fewer stocks in your portfolio, you increase the probability that you miss out on the top performance,” van Dijk says. 

“On average, it’s not the case that you’re going to do worse [than the benchmark], because, of course, there’s also a possibility that you do pick the Magnificent 7 within your 100 stocks, and then you might actually outperform. But it’s the uncertainty that’s the risk. 

“Maybe you’re very lucky, but you could also be very unlucky.” 

FOMO risk is a consideration not only during the stock-picking process, but also in deciding each stock’s portfolio weight, the rebalancing frequency and the trading strategy, the research said. The only way to reduce the FOMO risk would be to follow a portfolio strategy that minimises the risk of missing out on the next performing stock – effectively predicting the next Magnificent 7 – which is an extremely difficult objective as evidenced by active management’s struggles in recent years.  

But to optimise diversification within a concentrated portfolio, the research suggested that asset owners can implement maximum weights for individual stocks or maintaining industry composition and select stocks with low correlations.  

“In our simulation of 100 stocks, so a very concentrated portfolio, if you have very lucky picks, you will have an annual return on the portfolio – at least based on our historical sample – that is 3.5 percentage points per year higher than if you have a very unlucky pick of those 100 stocks,” van Dijk says. 

“As a pension fund, you have a 30-year horizon, if you have that year-on-year difference, it’s quite striking how important that [FOMO risk management] is.”