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Fund Spy

Some Funds Stay Too Close to Home

Hewing close to an index can limit risk, but it can also lead to mediocrity.

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It's not uncommon to ask a fund manager why the fund owns a particular stock and hear, "It's a big part of the benchmark." Managers sometimes consider it risky to stray too far from a particular index, in part because their pay and careers often depend more on how they perform against the indexes than they do on the absolute returns they generate.

Some funds can make benchmark-centric strategies work. For instance,  Vanguard Growth & Income (VQNPX), a quantitative fund that keeps its sector and industry weights close to those of the S&P 500, has outstripped that index in nine of the past 11 years. And in general, tying sector weightings to the benchmark or owning the largest index constituents can limit big performance divergences relative to a fund's index and category peers. But on the downside, hewing close to the benchmark can make it difficult to outperform, because benchmark-centric funds often won't take sizable bets on their favorites or shun their pans. Keeping sector weightings in line with a market index--a common tactic among benchmark-centric funds--can also keep a manager from throwing sufficient weight behind his or her best ideas. Benchmark-conscious funds can be hard hit when the market turns down because they are sticking to out-of-favor indexes. Moreover, some benchmarks don't make much sense and may be exposing shareholders to more risk because they concentrate assets in certain stocks and sectors.

Watered-Down Portfolios?
The point of active management is to find a fund manager whose strategy and/or stock-picking abilities will lead to long-term outperformance or at least make for a smoother ride than one could get by buying a cheap, well-diversified index fund. Unfortunately, actively managed funds that are tied too closely to their benchmarks can find outperformance and muted volatility harder to come by. Tying sector weights to those of the benchmark puts pressure on a manager to outperform with good stock picks, which is all the more difficult with active-management expenses tacked on top.  Federated Stock (FSTKX), which ties its sector weights to those of the S&P 500/Citigroup Value Index, demonstrates as much. The fund has consistently lagged its benchmark and its typical large-value peer. It's not clear that untying its sector weights would improve performance, but hewing so closely to the benchmark has been detrimental, as manager Kevin McCloskey's picks have often been wide of the mark and the fund has above-average expenses.

Marta Norton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.