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Wednesday, August 19, 2009

"The Best Stock Funds Don't Own Too Many Stocks" I Don' Think So

but they may be among the riskiest funds (my bolds, my comments italics)

from the wsj
Focused Funds Find Less Can Be More
Ups, and Downs, of Concentrated Investing


The best stock funds often don't own many stocks.
Focused funds -- portfolios with only a couple of dozen holdings -- are getting attention in a market where stock selection is more important than ever. Their concentrated strategy might be worth some extra risk for mutual-fund investors who know what to look for.
"It's very hard to find 100 great investment opportunities, but there can often be 20," said Charlie Bobrinskoy, co-manager with Tim Fidler of Ariel Focus Fund, which holds 23 stocks and sinks about half of its assets into its 10 largest positions. "Why put your money into your 100th or 50th best idea, when you can put it into your 6th or 19th best?"

Good question, but one fund investors usually don't get to ask. Most stock funds focus on diversification, and that means spreading assets across a wide field. The average stock fund has 172 holdings, according to investment researcher Morningstar Inc. The typical focused portfolio, meanwhile, tends to just 25 names.

Risk and Return
There is a reason so many stock funds are spread thin. Diversification is a tested way to control risk -- a stock that represents 1% or less of a portfolio can't inflict as much damage as a 5% position. Diversification's downside is that it limits a fund's chance to meaningfully outperform its index. Moreover, an overly diversified portfolio can mimic an index fund, but at a much higher cost (I would agree with that one. Which leaves investors with the following alternatives: build a low cost diversified portfolio with index funds or hold focused funds with more risk in the hope that a genius manager will generate higher returns) .

Focused-fund managers have little room for error, so they emphasize in-depth stock research. As an extra cushion, managers buy shares at a steep discount to what they believe they are actually worth.
"It's better to keep one basket and really watch that basket," Mr. Bobrinskoy said. "We've always been intrigued by Warren Buffett's statement that if you could make your 20 best investments, you would do really well."…..
The Advantage (?)

"If you know your companies extremely well and pay the right price for them, you have an advantage as it relates to managing risk," said Joe Wolf, a co-portfolio manager of RS Investors Fund, which owns 22 stocks. (that is a bit of a tautology, Basically Mr. Wolff is saying that if he is right he has an advantage over other investors. Of course if he is wrong, see the next paragraph for the outcome)
Yet having the courage of conviction means a focused fund, and its shareholders, are more exposed to the raw elements of the market. Accordingly, some years these funds will be wildly successful, but in others they will trail badly. (or to put it Mr. Wolff’s terms sometimes you have a big advantage by concentrating and sometimes you have a big disadvantage. (actually the opposite is true or at least the sentence is unclear. The focused funds are less of a trade impacted by the overall market (beta in the jargon of academic finance) and are more affected by the managers indicidual skill (alpha in the jargon). In plain english the market could be up or down but the focused manager thinks he has the skill to outperform by stocks selection. As is well know the odds are gainst him and given the high fees on the funds (see below) the odds that the investor will get to see those returns is even lower)

"You're not going to perform along with the S&P 500; there are going to be periods where you underperform, and perhaps not by a little," said Adam Strauss, co-manager of Appleseed Fund, which limits itself to 25 midcap and large-cap stocks.
A celebrated case in point is Oakmark Select Fund, a value-conscious portfolio with respected manager Bill Nygren(pictured here) at the helm.

To create the Select portfolio, Mr. Nygren winnows the less-concentrated Oakmark Fund to about 20 high-conviction names, with almost 60% of assets in the top-10 holdings. One of those stocks was Washington Mutual Inc., the banking giant that became a casualty of the subprime-mortgage crisis and was acquired by J.P. Morgan Chase & Co. At the peak, Washington Mutual commanded 15% of Select fund, and that hit hard in 2007 when Washington Mutual's shares lost 65% and the fund finished at the bottom of its group. (now there is an example of the perils if I ever saw one. With that concentrated holding the fund’s performance was pulled down by 9.75% and (see below)Washington Mutual was not the only hard hit financial services stock that was in his 20 stock portfolio So the portfolio was heavily concentrated by stock holding and even more so by industry/.

The WaMu Mistake
Mr. Nygren says he stuck with Washington Mutual in part because he had confidence in the company and didn't think housing prices would suffer such a major decline.
"Washington Mutual was a very large weighting in a position we were very wrong on," he said. "We still have a big weighting in financial-services companies, but it's spread out across more companies."

I did a quick check on some of the funds mentioned in the article as to performance in the big down year of 2007 and for industry/stock concentration and fees.
They are pricey, annual management feess:
Ariel Focus 1.29%
Oakmark Select 1.08%
RS Investors 1.98% (!)
Appleseed Fund 1.28%

And with one exception none did significantly better than the S+P 500 -36.7% in 2008. I would argue that the 2008 performance is a good proxy for the risk management of a portfolio.
2008 returns
Ariel Focus -35.1%
Oakmark Select -36.5%
RS Investors -49.5%
Appleseed -18.1% This largest holding for this fund is US treasuries =21% so this is a reflection of market timing not stock picking imo.

As for the focused strategy essential to generating higher returns it seems several of the funds have modified that approach.
Ariel Focus: largest holding Johnson and Johnson =6.3%
RS Investors : largest holding comverse technology 6.25%
The Appleseed Fund has a large concentrated holding but not in stocks: 21% in US treasuries
The only fund in this list with what could truly be called is Oakmark Select which is making a large bet on media with 9.8% in and 8.14% in liberty media

1 comment:

Tad Gage said...

While diversification has certain merits, why wouldn't you want skilled porfolio managers to go with their best picks? That's the primary benefit of selecting an actively managed fund. It should also be noted that The Appleseed Fund's cash position was 4% at the end of 2008. The rise to the current 21% level reflects an influx of new money to the fund and the managers' patience in finding optimal ways to invest that cash in stocks that are consistent with the fund's sustainability and value parameters.