Focus funds, highly concentrated (undiversified) and volatile equity mutual funds that are actively managed, are some of the worst performing funds of 2011. They typically own fewer than 50 stocks or have more than 50% of their funds invested in their top 10 holdings. They also have higher management fees. In an up year, focus fund managers may far outshine indexed and diversified funds. In a down year, they resemble mackerels rotting in the moonlight. Going from “manager of the year” to “chump of the year” in 12 months is not unheard of.
According to the recent Wall Street Journal (“When ‘Focused’ Funds Falter, Joe Light), the recent underperformance of focus funds offers ammunition to indexing advocates, who contend that most active managers do not beat their index benchmarks over the long term. It is mainstream portfolio theory that when it comes to indexing versus active management, indexing wins.
Likewise, in the world of active fund management, one would expect that focus funds would not beat diversified funds over the longer term. But that may not be true. Prestigious Emory University Goizueta Business School professors conducted a study that found that focus fund managers beat diversified managers by 4% per year after adjusting for fees.
The problem is that focus funds provide an extremely volatile ride. Legg Mason Capital Management Opportunity reportedly spiked up more than 84% in 2009 but has fallen by more than one-third this year. Investors tend to sell out when a fund goes down, and buy back in after it has recovered, with the result that they miss a lot of the gain. CGM Focus, run by manager Ken Heebner, has an average return of 10% per year of the past decade, but investors in the fund have a 7% loss of the same period, according to the article.
Are focus funds more volatile than diversified funds? In theory they should be. But recent market meltdowns took down diversified and concentrated funds alike.
According to the article: “If you are considering a focused fund, you should use money you won’t need for at least 10 years. [Emory] Prof. Bak’s research found that any outperformance was likely to appear only over long time periods.”
Retail investors need to be cautious during these times. The extreme swings in the market can be very dangerous.
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