Being Active: Why Diversification Is Harder Than It Looks
Diversification is a core principle of investing, yet in today’s markets it is often more elusive than it appears. Portfolios that look diversified can still share the same underlying risks. For us, that is why active management begins not with outcomes, but with how portfolios are built.
The Problem: When Diversification Becomes Superficial
Modern portfolios are often constructed around market-capitalisation-weighted benchmarks and organised by sector, region, or asset class. While this framework can appear diversified on the surface, it increasingly concentrates capital in the same dominant companies, styles, and risk factors.
The way investment research is structured across the industry reinforces this issue. Security analysis is typically conducted within specialist silos, each focused on a narrow part of the market. While efficient, this approach can fragment perspective, limit comparison, and obscure how risks overlap across portfolios.
The result is a form of headline diversification—many holdings, multiple regions, familiar sectors—but a reliance on the same underlying drivers of return. In such an environment, diversification can become accidental rather than intentional.
Why Markets Remain Inefficient
We believe these structural features create persistent valuation inefficiencies. When securities are analysed in isolation, relative value can be misjudged and risks misunderstood. Opportunities that fall outside traditional classifications may be overlooked, while popular areas of the market attract ever more capital.
Over decades of navigating global markets, we have developed a clear conviction: markets are inefficient in their assessment of risk and reward, and those inefficiencies are often amplified by benchmark-driven portfolio construction – whether by individual investors, financial advisors, or institutional allocators.
Index-led portfolios may reduce tracking error and the direct costs of investing, but they can also embed concentration risk precisely when valuations are most stretched. When index concentration is at its highest (from the 1970s when “blue chip” stocks dominated to the dotcom and internet peaks of the early 2000s to today’s AI-led market) the benefit of active management that prioritises fundamental analysis and relative value over index alignment is arguably greatest.
Our Response: Active by Design
Being active is a deliberate choice. Our investment process is structured to challenge the limitations of siloed research and index-centric thinking. Culturally, independent thinking and truly active management require curiosity and a sustained focus on long-term results. Intellectually curious colleagues who comprise our investment team come together in our unique location in Santa Fe, New Mexico to carry out this discipline of active management. We embrace the limitations of what we know, bring curiosity to what we don’t know, and update our thinking based on new data and new information. Our frame of mind is not to be right, but to get as close as possible to the right answer.
Organizational structure must support and reinforce this philosophy and collaboration is central to our approach. By encouraging research across sectors, regions, and asset classes, opportunities can be compared on the basis of relative risk and reward rather than benchmark membership. On our team, ideas are debated collectively, bringing multiple perspectives to bear before capital is allocated.
Crucially, investment decisions are not made in isolation. Potential holdings are evaluated simultaneously within the context of the portfolio, ensuring that each position contributes meaningfully to portfolio balance and resilience.
Rethinking Portfolio Construction: Less Can Be More
One of the most common misconceptions in investing is that diversification requires scale. In practice, holding 100 or more stocks does not necessarily reduce risk, particularly when many positions share similar exposures to sectors, styles, or macro forces.
A more focused, high-conviction portfolio can deliver diversification when we have deep knowledge about each company, and when each holding is selected intentionally for its role within the overall portfolio. This approach to portfolio construction reflects our belief that diversification should be deliberate rather than diluted across marginal positions.
By concentrating capital in a smaller number of well-researched investments, each holding must earn its place. Position sizing is informed by valuation discipline, downside risk, and correlation with other holdings, allowing diversification to be achieved at the portfolio level while we remain selective at the security level.
Concentration, in this context, is not a source of risk but a tool for managing it. True diversification comes from owning businesses with differentiated drivers of return, not from increasing the number of names in a portfolio.
Measuring Risk Differently
Traditional portfolio analytics can be helpful, but they are often blunt instruments. Many define risk primarily as deviation from an index, which can overstate risk in concentrated portfolios and understate risk in index-like ones.
Our definition of risk is more fundamental. The focus is on the potential for permanent capital impairment, the margin of safety embedded in valuation assumptions, and the durability of a company’s competitive position. These considerations underpin both security selection and portfolio construction.
From this perspective, tracking error is not a flaw to be minimised but a by-product of deliberate diversification.
Why This Matters Now
Today’s market environment has brought these issues into sharper focus. Market-capitalisation-weighted benchmarks have become increasingly concentrated, while correlations across regions and sectors have risen. As a result, diversification has become harder to achieve just as it has become more important.
Portfolios that rely on index exposure or headline diversification may be more vulnerable than they appear. In contrast, an active, high-conviction approach built around deliberate portfolio construction offers an alternative path.
By making intentional choices, challenging silos, and diversifying by source of return rather than by label, investors can seek portfolios designed to be more resilient in an increasingly concentrated world.
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