When Your Fund Focuses On A Flop
As news of apparently questionable accounting at Cendant Corp. slashed its stock price nearly in half on Apr. 16, Cendant shareholders weren't the only ones sweating. Investors in the Morgan Stanley Institutional Fund's Aggressive Equity Portfolio, which held a large position in Cendant, saw their holdings drop 6.7%.
Cendant's plight underscores the dangers to investors in highly concentrated, or "focused," mutual funds, which are growing in popularity. Unlike the typical domestic stock fund, whose bets are spread among an average of 135 holdings, these portfolios hold relatively few issues, sometimes as little as 15. That's how many are held by the dean of this group, Sequoia Fund, whose 28-year record of superior performance often is Exhibit A in the case for concentrated portfolios.
UGLY CRASH. The Morgan Stanley fund had 28 positions, according to Morningstar Inc., but because Cendant, at nearly 13.4% of the portfolio, was its second-biggest, the effect when Cendant crashed was ugly. "It certainly points out the risks in concentration," says Morningstar equity-fund editor Russel Kinnel. "One of the arguments for concentrated funds is that it allows [fund] managers to follow their picks more carefully. Obviously, that doesn't always work out."
Does this mean investors should steer clear of focused funds? Not necessarily, particularly if a focused fund is only part of a typical fund investor's portfolio. "If you avoid flaky companies, it doesn't become a problem," says Thomas F. Marsico, manager of Marsico Focus Fund, whose 25 or so stocks have climbed 29.5% in value so far this year.
Just the same, investors in focused funds need to keep a sharp eye peeled on where portfolio managers are placing their bets. Are big chunks of the portfolios deployed in low-risk "value" plays? Or are they riding on another high-flying Cendant?
To shed some light on that, BUSINESS WEEK studied Morningstar's Principia Plus database of more than 9,000 funds. The list was whittled down first by looking only at general domestic stock funds of at least $25 million in size and with minimum initial investments of no more than $10,000. Next, the list was winnowed to portfolios with 25 or fewer holdings. That left just 20 funds, including Sequoia and other renowned names such as Longleaf Partners, Clipper Fund, and G. Kenneth Heebner's New England Growth Fund.
From there, using Principia, BW compiled a list of all the stocks held by the 20 funds (table). Far and away these focused funds' biggest exposure was to Warren Buffett and his Berkshire Hathaway Inc. Three funds hold a total of nearly $1 billion worth of Berkshire (specifically, the Class A shares; one also holds Class B shares). Nearly all of that, however, is held by Sequoia, which at last report had more than 31% of its chips on Buffett.
One curiosity: Of the 321 stocks held by these 20 funds, most of them--266--are held by just one. This is a crowd with a broad range of tastes: No stock is held by more than five funds. Those held by five include: insurer American International Group, computer networker Cisco Systems, PC maker Compaq Computer, and mortgage packager Freddie Mac.
Where are the outliers? The contrarians Mason Hawkins and Staley Cates, who run Memphis-based Longleaf, are happy to invest heavily in some lonely spots. They are by far the biggest mutual-fund investor in Knight-Ridder Inc., with nearly 13% of Longleaf devoted to the company. With 7.6% of assets in FDX Corp., Longleaf also is highly exposed to the parent of Federal Express.
Longleaf is one of Morningstar's highest-rated, five-star funds. Nonetheless, with its high concentration of assets in a few stocks, if one were to crater a la Cendant, fund holders would suffer much as Morgan Stanley's did. As it happens, the Morgan Stanley fund's manager, Kurt Feuerman, also has earned five stars from Morningstar for two similar, older funds that he runs. Feuerman defiantly points out that before Cendant, his fund was ahead more than 20% this year. It remains up 13.4% year-to-date, and has gained 201% since its March, 1995, inception--twice the gain in the average capital appreciation fund over that stretch, as followed by Lipper Analytical Services Inc. "Despite this hit," Feuerman says, "the fund's long-term record is spectacular."
Is Feuerman planning to change his ways? Only, he insists, by "putting more of my own money in the fund." Investors who follow suit should make sure their dispositions can deal with the potential agonies.