Morgan Creek Capital Management’s Mark Yusko has been a vocal critic of ETFs. More recently he decided to join the enemy by launching his own of ETF, reports Bloomberg.
While the development is noteworthy, the nature of the fund is also significant—it will typically invest in only 10 securities. By doing so, the fund’s portfolio will represent the company’s best 10 investment ideas.
On one hand, the concept of a concentrated fund runs contrary to accepted practices of managing security-specific risk, or idiosyncratic risk, with diversification. Indeed, many funds may hold more than 100 securities.
Other funds hold even more. American Funds’ Growth Fund of America typically owns more than 285 equities while Fidelity’s Contrafund typically holds more than 335 positions.
Yet, Yusko is far from being alone in embracing focused funds. Noted stock picker Tom Marisco, for example, has funds that generally have fewer than 60 holdings. The firm’s Focus Fund, furthermore, invests in fewer than 30 equities.
Aston/Fairpointe also embraces portfolio concentration and offers the Aston/Fairpointe Fund, which has approximately 32 holdings. A handful of research argues that concentrated portfolios have a performance advantage while still being able to manage risk.
In the book Modern Portfolio Theory and Investment Analysis, researchers maintain that a 1,000 stock portfolio can be 61% less volatile than an individual stock, while a 20 stock portfolios reduces risk by 59%, or nearly as much as the more broadly diversified portfolio, writes James K. Glassman, who is a contributing columnist with Kiplinger.
At the same time, portfolio managers’ largest weighted stocks, or the highest conviction holdings, tend to outperform, while lower conviction positions tend to be a drag on performance.
That concern is illustrated by a research paper titled “paper ,” which concluded that broadly diversified funds, or “closet benchmark huggers,” tend to underperform their benchmarks by 1.4 percentage points. Other studies have shown that highest conviction holdings tend to outperform.
Those reasons in themselves may be enough for fund firms to justify launching concentrated funds. Yet, from a more cynical perspective, other factors may be at work. One factor may simply be active managers seeking a second try at outperforming their benchmarks after a bruising few years.
According to the midyear paper (PFA), during the one-year period ended June 30 of this year, 84.62% of large-cap managers, 87.89% of mid-cap managers, and 88.77% of small-cap managers underperformed the S&P 500, the S&P MidCap 400®, and the S&P SmallCap 600®, respectively.
For the five-year period ended June 30, 91.91% of large-cap managers, 87.87% of mid-cap managers, and 97.58% of small-cap managers lagged their respective benchmarks. Results were also disappointing for the 10-year period.
Arguing that excessive diversification, rather than the merits of active management and portfolio manager skill, has caused underperformance can give active managers who launch focused funds a second chance at winning clients by arguing that their new products have increased potential for beating their benchmarks.
At the same time, firms can scrub underperforming diversified fund, thereby burying bad performance and making the aggregate results of remaining funds look more appealing.
Not everyone is a fan of focused funds. Not surprisingly, S&P, which generates revenues by licensing its benchmarks, has issued a paper (PDF) that says concentrated portfolios require specialized portfolio manager skills and can increase trading costs and volatility.