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Focusing on a manager's best stock ideas may not be a good idea
STOCK funds with concentrated portfolios - 30 or 40 holdings, tops - are supposed to contain only the managers' best investment ideas.
It turns out, though, that those ideas generally haven't been good enough to help the funds beat more diversified rivals.
In the first quarter, and in the one, three and five years that ended on March 31, the average such stock fund, known as a focus fund, failed to beat at least half of the funds with the same objective - large-company growth, Asian smaller companies, whatever - according to Morningstar.
At our request, Morningstar examined all actively managed stock funds that had no sales load, a minimum investment of US$10,000 or less and at least US$100 million in assets. A focus fund was defined as being in the 10 per cent of funds with the fewest portfolio holdings, meaning it owned fewer stocks than any of the other 90 per cent.
Despite the so-so performance of focus funds as a group, some did exceptionally well, and that reveals the good and bad news about them: Their portfolio concentration can accentuate the gap between the best and worst.
"Concentration can propel you to greater heights and drive you to greater depths," said Christopher Davis, a senior analyst specialising in equity strategy for Morningstar. "A concentrated fund is harder to own."
Amid the ordinariness, or worse, there were many apparent standouts. A greater number of concentrated funds performed in the top 10 per cent within their respective investment objectives in each period than would have been expected by chance, the Morningstar data reveals.
In the year through March, for instance, in a universe of 1,938 funds, 19 or 20 in the group with the 10 per cent fewest holdings should have been in the top 10 per cent of returns, strictly by chance, but 26 were.
Todd Rosenbluth, director of exchange-traded fund and mutual fund research at CFRA, views the wide performance range among focus funds as a silver lining.
"Concentrated funds put only their best ideas into the portfolio and tend to stick with them," he said. "They can be more volatile, as they are driven by a smaller number of stocks and tend to be more concentrated in certain sectors." That may give any of them a chance to beat the market.
Diversified portfolios, in contrast, may not deviate much from benchmark stock indexes, he said, and so "are more likely to lag a considerably cheaper Vanguard index mutual fund". The potential to substantially outperform allows providers of focus funds to charge more money. The average focus fund has annual expenses of 1.06 per cent, compared with 0.98 per cent for the average actively managed stock fund, according to Morningstar. Focus funds also typically have smaller asset bases, providing fewer economies of scale.
"Concentrated funds start off deeper in the expense hole and have a deeper expense gap to traverse," Mr Davis said. "If you bet on the right one, your upside potential is all that much greater. Investors choose to make that bet. If they choose well, the expense ratio doesn't really matter. If they don't, the additional expenses will add insult to injury."
There have been clear, consistent winners among focus funds, even if their inherent volatility can cause periodic weakness. Many names appear on several lists of top concentrated portfolios this year and over one, three and five years, with seven funds on all four.
One of those, Guinness Atkinson Global Innovators, maintains a portfolio of about 30 stocks. They are often the same ones, because the managers like to hold positions for many years.
As the fund's name suggests, its managers "try to identify companies that use innovation to drive their growth", said Matthew Page, one of those managers. "We believe that, ultimately, companies like that should outperform, because they're smarter and better than their average peers. That means higher growth prospects and profits."
Among the themes that appeal to him are big data and machine learning. The first refers to the storage, processing and analysis of immense sets of related data. The second involves developing programs that allow computers to learn from and make predictions about data almost instantaneously, a skill that will be needed for technologies such as self-driving cars.
It's hard to invest in these areas directly, Mr Page said, so the portfolio holds stocks in related ones, including Nvidia, which makes graphics processing units; Fanuc, a Japanese robotics business; and Infineon, a German maker of semiconductors for the automotive industry that is expanding into chips for electric and self-driving vehicles.
The Baron Fifth Avenue Growth fund, another that appears on all four lists of top-performing focus funds, favours large companies that sell for less than their intrinsic worth because investors misunderstand their businesses, Alex Umansky, the fund's manager, says.
He adds that there are so few mispricings among these well-researched companies that the fund usually holds just 30 to 35 stocks.
He keeps most of them for long periods - "our time horizon is forever", he said - and accepts fund price swings that other managers try to avoid by maintaining bigger portfolios.
"We think over-diversification has been massively value-destructive over the last decade because people are worried about managing volatility," Mr Umansky said.
The fund's largest constituent, accounting for 15 percent of its assets, is hardly obscure - Amazon - but Mr Umansky contends that its price is too cheap, even at 235 times its earnings for the last four quarters.
That extravagant valuation is misleading, he said, because Amazon has a history of forgoing earnings today by investing in new business lines that will pay off tomorrow.
Other portfolio holdings include Alibaba, a Chinese e-commerce giant; and Mastercard and Visa, which dominate the credit card business. Mr Umansky called Mastercard "the digital railroad" taking financial transactions from paper to the electronic world, a process that he expects to be larger and more lucrative than investors anticipate.
Mr Rosenbluth recommends the Guinness Atkinson and Baron funds. Others that he likes and that appear on at least one of the lists of top-performing focus funds include Columbia Select Large-Cap Value, Axa Loomis Sayles Growth and Parnassus Endeavor.
Mr Davis is a fan of the Baron and Parnassus funds, although he is agnostic about focus funds generally.
"We haven't been able to discern a real advantage investing in concentrated portfolios, but there's not a big disadvantage, either," he said.
"You should expect to have a range of outcomes the more concentrated the portfolio is," he added. "Even some of the best performers over the last five years underperform their peers sometimes." NYTIMES