Some Funds Stay Too Close to Home

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.

Plus, sticking close to an index may mean a fund won't be able to avoid a market downturn as easily as its less-constrained peers. That's because funds tethered to their benchmarks follow the indexes in good times and in bad, while funds with looser mandates have the ability (if not always the foresight) to sidestep trouble spots. For example, the older institutional share class of  JP Morgan Disciplined Equity (JDESX), a large-blend fund that ties its sector weightings to the S&P 500, was a category laggard during the bear market stretching from 2000 through 2002, partly because its devotion to the S&P 500 meant it had more in the hard-hit technology stocks than its typical peer.

A benchmark-centric approach is all the more frustrating when it keeps the fund from making the most of its resources. Take  AllianceBernstein Value (ABVAX). The fund has seasoned management and a deep bench of analysts, but it is still benchmark constrained. It won't bet heavily against the largest stocks in its benchmark, the Russell 1000 Value. That means the fund can end up diluting its high-conviction ideas with stocks it owns merely because they're in the benchmark. Not surprisingly, the fund's three-year R-squared clocks in at 98%, meaning that 98% of its returns can be explained by the movements of the Russell 1000 Value. It's lagged the lower-priced  iShares Russell 1000 Value Index (IWD) in most rolling one-year periods since its 2001 inception.

Bogus Benchmarks
Funds face even bigger problems when the indexes they focus on are poorly constructed or don't make much sense as the basis for a portfolio. Fidelity OTC (FOCPX), for instance, tries to beat the Nasdaq Composite Index and must keep 80% of its assets in Nasdaq-listed names. That's a tough mandate for shareholders, regardless of whether the fund meets its objective (it hasn't consistently), because the index is awkwardly defined. It stores roughly half of its assets in technology stocks. That's not enough to make the index a pure play on the technology sector, but it's too much to keep it well diversified. As a result, this fund's shareholders have had a wild ride (the fund's 27% standard deviation of returns for the 10-years ending July 31, 2007, is 8 percentage points higher than that of its typical large-growth rival) and haven't made much money along the way. The fund returned 6.8% for the 10-year period ending July 31, but Morningstar Investor Returns, which use asset flows to track the typical investor's experience, suggest the fund's average investor gained only 3% over that same period.

We also call into question some of the actively managed funds that try to beat narrowly defined sector indexes while at the same time hewing close to them. With an increasing number of cheap sector-focused exchange-traded funds available, these areas are far more competitive. Because the actively managed funds have bigger expense ratios and can often fall short of their indexes with poor stock picks, we think the ETFs can be better bets. Given the right valuations, for instance, we'd opt for iShares Dow Jones US Insurance (IAK) over the pricier  Fidelity Select Insurance (FSPCX). Although the iShares tracks a different benchmark, it has a similar portfolio. It holds many of the same stocks and also stores lots of assets in the industry's biggest companies.