The best time to open an account with Bill Miller's Legg Mason Value Trust (LMVTX), the fund manager states in his latest shareholder letter, "has always been when we've had dismal performance."
If so, now is a golden opportunity—the legendary value manager's fund, which holds only 30 stocks, is down 32% over the past year. While Miller advocates a buy-and-hold strategy with his concentrated portfolio, hanging on to his fund over the past decade has meant enduring high volatility and above-average fees only to do worse than the Standard & Poor's 500-stock index. Miller's current woes are somewhat tied to the credit crisis. But a recent study of so-called focused funds holding fewer than 40 stocks found that their managers generally fail to manage the downside risk of their portfolios.
The study, "Security Concentration and Active Fund Management," analyzed returns for 2,278 U.S. stock funds from 1984 to 2002. It found that, on average, focused funds underperformed their benchmark indexes and more diversified peers on a risk-adjusted basis by more than 1% a year. The average actively managed fund showed no discernible difference in performance from the market and beat focused funds before and after expenses. (Focused-fund expenses are an average 1.5% compared with 1.27% for the average equity fund in the study. Expenses at Legg Mason Value are 1.68%.)
The focused-fund strategy is to hold a small basket of stocks with the hope that a manager's best ideas will beat the market. The problem, of course, is that the funds suffer a greater risk of company-specific blowups. Recent instances include Miller's holding of Freddie Mac (FRE) and Oakmark Select's (OAKLX) investment in Washington Mutual (WM), which made up 16% of the fund at one time and which manager Bill Nygren rode from 45 a share to its current 4.58. Nygren, like Miller, declined to be interviewed.
There's a flip side to such volatility: In good years, it leads to performance that can attract a lot of assets. Travis Sapp, a professor of finance at Iowa State University—who, with University of Missouri-Columbia professor Xuemin Yan, co-authored the fund study—speculates that "less skilled money managers may gravitate toward running more focused funds" because of that chance to take a gamble and win big. But the attrition rate among focused funds reveals their tendency to lose big as well. Although Legg Mason Value has been around for 26 years, the study found that from 1984 to 2002, 38% of focused funds were either liquidated or acquired and merged out of existence. For more diversified funds, the rate was 18%.
That doesn't mean you should avoid all focused funds. But limit your exposure. "I don't put more than 5% [of a client's assets] with any of them," says New York financial adviser Lewis J. Altfest, who uses several focused funds in client portfolios. "If one fund is in trouble, another is usually doing well." Try to buy funds that emphasize risk reduction. Miller's claim to fame was beating the S&P 500 for 15 years, but other managers want to make a profit no matter what. "Our No. 1 rule is don't lose money," says Bruce Berkowitz of the 22-stock Fairholme Fund. "It doesn't bother me if shareholders leave because we underperformed on the market's upside, but I'd be very unhappy if they left because we [performed worse] on the way down." Fairholme, launched in 1999, had its worst calendar year in 2002, when it lost 1.6% and the market fell 22%. (It's down 0.6% this year.)
Berkowitz employs risk-reducing tactics that differentiate him from peers. Fairholme's cash position is usually in the double digits, compared with the 6.6% average for focused funds in Morningstar's database and under 1% for Legg Mason Value. Berkowitz says the cash mutes volatility and allows him to manage shareholder sales: "We don't want to be in a position where our investors are redeeming our shares and we don't have the cash to pay them. That would force us to sell positions we like at a loss." He also wants stocks he owns to have lots of cash and a low debt level (the fund holds Berkshire Hathaway (BRK.A), for example). That's leagues away in style from managers such as Miller, who got burned betting on beaten up, highly leveraged financial stocks.
One stat to pay close attention to with focused funds is called "beta." It measures the volatility of a fund relative to its benchmark, and can be found on a fund's page on Morningstar.com under "risk measures." A beta of 1.0 would mean a blue chip stock fund would be just as volatile as the S&P 500. Fairholme's beta is 0.91, meaning it is 9% less volatile than the S&P, while Legg Mason Value's is 1.42, meaning it is 42% more volatile. Screening for low-beta focused funds uncovers such recent winners as Osterweis Fund (OSTFX) and Jordan Opportunity (JORDX). Both focus on risk reduction—Osterweis by holding cash, Jordan through hedging via put and call options (puts are a bet that prices will fall; calls are the opposite). They've kept risk levels lower than the S&P 500.
Have these managers just been lucky, and Miller and Nygren just unlucky? Perhaps. Maybe Miller will even make a comeback, but the whole notion of beating the market as a goal seems a throwback to happier days when stocks went up all the time. With the S&P 500 down 11% this year, beating the benchmark doesn't seem quite so ambitious anymore.