|S&P 500||5.09%||13.60%||9.52%||Large-cap stocks|
|Nasdaq Composite||8.99%||19.00%||19.50%||Large-cap tech stocks|
|Russell 1000 Growth||4.99%||12.75%||11.55%||Large-cap growth stocks|
|Russell 1000 Value||6.46%||15.83%||10.19%||Large-cap value stocks|
|Russell 2000 Growth||11.27%||21.80%||17.08%||Small-cap growth stocks|
|Russell 2000 Value||10.21%||20.68%||14.55%||Small-cap value stocks|
|MSCI EAFE||6.07%||16.27%||6.95%||Europe, Australasia & Far East Index|
|Lehman Aggregate||1.86%||2.71%||4.14%||U.S. Government Bonds|
|Lehman High Yield||1.03%||7.02%||15.17%||High-yield corporate bonds|
|Carr CTA Index||5.30%||6.31%||11.28%||Managed futures|
|Through May 31, 2003.|
According to a recent study by Standard and Poor’s, investors who want to achieve exceptional returns should consider concentrated mutual funds rather than diversified stock funds (the study is available at http://www.investmentadvisor.com/article.php?article=1668).
The study found that, on average, the 329 mutual funds with a 10-year performance history and at least 30% of their assets in their top 10 holdings outpaced non-concentrated funds on both an absolute and a risk-adjusted basis. Unfortunately, S&P’s conclusions raise more questions than they answer.
For starters, consider the fifth and sixth words of the above paragraph. Concentrated funds might beat other funds on average, but that does not mean that any concentrated fund will perform like the average fund in its peer group. It’s a well-known fact that concentrated funds are at either the top or the bottom of return rankings in any given year. And even if one makes the assumption that all concentrated funds are open for new investment (the best ones have been closed for years), the only way to get the “average” performance of all concentrated funds is to buy all of them, which would result in–egad!–a diversified portfolio.
Such an approach would also yield a rather expensive diversified portfolio. Most concentrated funds levy hefty front-end loads and sport higher management fees than diversified offerings.
There are no doubt a plethora of readers wondering where Warren Buffett fits into this argument. The Oracle of Omaha is legendary for both his stunning long-term performance and his predilection for amassing large holdings of just a few stocks. “We are reminded that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy. On that view, risk rises when investments and investment thinking are spread too thin,” he says in The Essays of Warren Buffett (John Wiley, 2001). That may be, but one should note that according to the latest Berkshire Hathaway shareholders’ meeting, about 38% of the firm’s assets are dedicated to fixed income trading. Sounds like diversification to me.
My response to the concentrated portfolio issue is simple. RIAs should strive not to maximize return, but to create a process where gains are possible, if not probable, in a vast majority of market conditions. With that, consider the mighty 60-40 stock-bond blend. Not only does it trounce concentrated fund returns over the long haul, it does so with far less risk.
Do concentrated funds have a place in a well-constructed portfolio? Perhaps, but I wouldn’t consider one unless that manager has a good track record and the ability to go short (like in a hedge fund), which serves to reduce beta during difficult market conditions.