Focus Funds: Does Concentration of Risk Improve Returns?

There is a large body of evidence demonstrating that, on average, actively managed funds underperform appropriate risk-adjusted benchmarks. One often-heard excuse for their failure is that the typical fund is “overdiversified” — by owning so many stocks the value of the manager’s best ideas are diluted. Even Warren Buffett seems to agree with that hypothesis. Here is what he had to say about diversification: “Wide diversification is only required when investors do not understand what they are doing.”

The mutual fund industry’s solution (or sales pitch) to what Buffett called “di-worse-si-fying” portfolios is to create “focus” funds: funds that concentrate the fund’s holdings in the manager’s best ideas. While most mutual funds hold well over 100 stocks, the typical focus fund will hold 40 or less. There are even funds that hire several submanagers for just their single best pick.

The question for investors is: Does concentration of risk improve returns? Travis Sapp (Iowa State University) and Xuemin (Sterling) Yan (University of Missouri–Columbia) sought the answer to that question in their 2008 study, “Security Concentrations and Active Fund Management: Do Focused Funds Offer Superior Performance?”¹ Their database covered the period from 1984 through 2002, and contained 2,278 funds comprising 16,399 fund-years. The study excluded funds with less than 12 holdings and as well as those with less than $1 million in assets. The following is a summary of their findings:

• There was no evidence that focused funds outperform diversified funds. In fact, after controlling for other fund characteristics, funds with a large number of holdings significantly outperformed funds with a small number of holdings both before and after expenses. In other words, fund performance is positively, not negatively, correlated to the number of securities in the portfolio.
• The quintile of funds with the fewest holdings realized an economically and statistically significant annual three-factor alpha (return above benchmark, accounting for the exposure to the risks of the overall market, small stocks and value stocks) of negative 1.44 percent.
• At the one-year horizon, the buys of focused funds underperformed their sells by 0.3 percent.
• Focused funds have significantly higher return volatility and tracking error to benchmarks. Investors were taking greater risk while earning lower returns.
• Focused funds held considerably larger cash positions, 12.8 percent versus 7.8 percent for diversified funds. Cash acts as a drag on returns for equity funds.
• The attrition rate of focused funds is higher than that of diversified funds.

Strategies Don’t Have Costs, Implementing Them Does

One explanation for the underperformance is that the larger the ownership stake in a firm becomes, the greater the trading costs — the fund cannot react quickly to new information without incurring significant market impact costs. As the authors noted, “even if managers of focused funds have better stock-picking ability, their funds might not perform better than diversified funds because of liquidity problems.” Once trading costs are added to the burden of their relatively high operating expense ratios, achieving a risk-adjusted alpha becomes difficult.

Another explanation for the failure of focus funds is that the market is sufficiently efficient that after expenses it becomes difficult to exploit any prices errors.

While not all focus funds have delivered poor returns, the following is an example what can happen when investors concentrate risk.

Hocus Focus

James D. McCall, manager of the PBHG Large Cap 20 Fund, was one of the shining stars of the mutual fund world in the late 1990s. In the two and a half years McCall ran it, the fund ranked first among its peer group (large growth funds) and provided investors with average annual returns in excess of 50 percent.² Merrill Lynch (MER) hired him away to run the Merrill Lynch Focus 20 Fund. The fund was launched to great fanfare in March 2000. At the time, it was the largest IPO ever for a mutual fund, raising over $1 billion from investors. Ultimately, the fund raised over $1.7 billion,⁴ a tribute to the “thundering herd” — Merrill Lynch’s marketing machine of stockbrokers. Unfortunately for investors, in 2001, the B shares of the fund [MBFOX] lost 70.4 percent. In 2002, the fund lost a further 40.0 percent, for a cumulative two-year loss of 82 percent.⁵ Those performances earned the fund category percentile rankings of 99 and 97, respectively.⁶ It is worth noting that the fund had an expense ratio of 2.2 percent. As Rex Sinquefeld, former cochairman of Dimensional Fund Advisors, noted, “poor performance doesn’t come cheap, you have to pay dearly for it.” The fund is now called the BlackRock Focus Growth Fund.

The June 1998 issue of Money also provided us with evidence that the “overdiversification” excuse doesn’t hold water. Money, with assistance from Chicago consulting firm Performance Analytics, reviewed the performance of 22 private account managers whose performance placed them in the top 20 percent of their peer group. Each firm provided their single best idea. For the period beginning in May 1996 and ending in mid-June 1998, the average return of the 22 best picks was 53.5 percent, or a negative value added of 13.2 percent when compared to the return of 66.7 percent for the Wilshire 5000.

Summary

The aforementioned findings clearly do not support either the view that managers holding focused portfolios have superior stock-picking skills or that focused funds provide value to investors. We don’t know if Warren Buffett was right when he said: “Wide diversification is only required when investors do not understand what they are doing.” However, if he is correct, the average focus fund manager clearly doesn’t know what he or she is doing.

For them, and their investors, broad diversification would have proven to be the winning strategy. And the most efficient way to achieve broad diversification is through low-cost, passively managed funds (e.g., index funds). And that is why even Warren Buffett has concluded: “By periodically investing in an index fund the know-nothing investor can actually outperform most investment professionals.”

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.

Footnotes:

1. Travis Sapp and Xuemin (Sterling) Yan, “Security Concentrations and Active Fund Management: Do Focused Funds Offer Superior Performance?” The Financial Review 43 (2008) p. 27–49.
2. Patrick McGeehan, “Relentless Search for Growth Humbles a Mutual Fund Star,” New York Times, August 23, 2001.
3. Business Wire, March 13, 2000.
4. James M. Clash, “Penny-Pincher,” Forbes, December 10, 2001.
5. finance.yahoo.com.
6. Morningstar.com.
7. 1993 Berkshire Hathaway Annual Report, p. 15.

Comments

[THofler]

Thank God someone has had the courage to puncture that underperforming blowhard Warren Buffett!

Oh, wait a minute; his performance has been pretty spectacular. I guess he's just been very lucky for the last 50 years.

Here is some ABC-type news: Most active mutual fund managers are not very good investors. Hence ALL inclusive statistical analyses of mutual funds are worthless. There are lots & lots of bozos out there & once you fold them into the data it becomes a case of garbage-in/garbage-out.

Fortunately the mutual fund investor does not have to throw darts at a fund list. Sure, smart fund picking is not easy, but it's easier than buying individual stocks.

2nd point: While high volatility adds greatly to short term risk, volatility does not equal risk over the long term (unless you define them to equal). Which is riskier? A low volatility fund that consistently loses money, or a high volatility fund that grows rapidly?

I don't know that a great fund must be focused in order to be great, but I do know that some of the best are focused. My favorite fund has averaged 23.9% annualized return since it's inception 10.5 years ago & it has a 40.5% annualized return since I started investing in it 2.4 years ago. I'm talking about the CGM Focus fund (CGMFX) run by the almost legendary Ken Heebner. IMHO Ken is worth every penny of his 1.27% expense ratio.

[Ray Meadows]

"Does concentration of risk improve returns?" is really not a very good question as it stands. Statistically the answer must be no if you have a large enough data set. Concentration of risk only improves returns if you have a manager with real skill. Warren Buffet is right and when we talk about "average" mutual fund managers then by definition we are talking about those who do not know how to outperform and so they may as well diversify to keep risk low and only lag benchmarks by their expense ratio (on average). It is obvious that any large study such as the one cited must have these findings whether looking at forcused funds or diversified funds. Over the last 9 years I've managed to earn a cumulative return of 398% - by never holding more stocks than I can truly understand and follow closely (i.e. < 40). Every other manager I know of with a similar track record has a similarly concentrated portfolio. Perhaps that is the more interesting study: of the managers with demonstrated skill, how many use a conscentrated risk strategy. My guess is it would be north of 80%.

[mkreisel]

Bozos running concentrated portfolios will be wiped out sooner than later.

This article conveniently ignored that plenty of those mutual fund managers are bozos.