by Josh Charlson
In the old TV game show ?Concentration,? contestants tested their powers of recall and mental agility by trying to find the pairs of matching squares, then decoding the pictorial message hidden beneath. The winner garnered cash and prizes, while the loser got a harsh buzzer and a quick exit.
These days there's a new game of concentration being played that's every bit as much a high-stakes trial of intelligence and guts as the old one, and it's coming soon to a mutual fund near you. Concentrated funds--also known as focused, compact, or nondiversified funds--have become something of a trend in the marketing-driven world of mutual funds. The surprise, though, is that many of these newer concentrated funds are being put out by some of the most respected shops, including Oakmark, PBHG, Yacktman, and Vanguard.
Certainly, concentrated funds make sense from a marketing standpoint. They allow companies to showcase their top talent and to create spin-offs of other successful funds. And because fund companies can't really distinguish themselves with index funds (except on the basis of expenses, which Vanguard has wrapped up), why not try to stand out by getting as far away as possible from the passive-investing mentality? But they also make sense from an investing standpoint. Index funds have their place in a portfolio, but many investors don't want to settle for average returns all the time. A number of the most renowned managers, like Bill Ruane and Rick Cunniff at Sequoia Fund, Bill Sams at FPA Paramount, and Ken Heebner at CGM Capital Development, have preferred to focus on a few of their very best ideas. World-class investor Warren Buffett has never seen the need to stuff Berkshire Hathaway with 100 stocks.
Academic theory tends to support these intuitions; most studies recommend that individual investors hold between eight and 20 stocks to achieve an optimal balance of risk and reward. But several recent studies conducted at Morningstar cast doubt on these suppositions. Our research finds, contrary to the conventional wisdom, that in practice concentrated funds tend to have higher risk and lower returns than the average fund, whether one uses the broad equity universe or individual categories as a benchmark.
Do these findings negate the value of concentrated funds for individual investors? Hardly so, any more than the difficulty of beating S&P 500 index funds eliminates the case for active management. What our linear-regression studies do indicate is that concentration is no guarantee of superior performance. Although our research looks at real (rather than theoretical) mutual fund portfolios, we are also examining the average of these funds, and the sad truth is that the average manager of a concentrated fund is no better than the average manager of a diversified fund. If anything, it's harder to successfully steer these vehicles: They're often loaded up in a given sector, making them far more sensitive to the market's whims, and the risk of a single stock torpedoing overall performance is always present. Concentrated funds are, by their nature, a stage for stock-pickers, and most stock-pickers just don't have the talent to achieve the consistently superior performance that creates stardom.
Given these qualifications, how can an investor most profitably go about finding a concentrated fund? Are there characteristics than can help distinguish the winners from the losers? And what is the place of concentrated funds in a diversified portfolio?
Before turning to these questions, though, it's necessary to first figure out what exactly is meant when we talk about concentrated funds. There's no set definition for these funds, so different people may mean different things when they use the term concentration. The most common reference point is number of stock holdings--a number less than 30 or 40 indicates a high degree of concentration. You can also look at the percentage of assets squeezed into the fund?s top 5 or 10 holdings.
But numbers alone don't tell the whole story. Combining statistical measures with more subjective measures of managerial and corporate style, we've come up with three additional ways to categorize a given concentrated fund, and some advantages and pitfalls of each.