Stock Diversification Doesn't Always Lead to Blandness

At Morningstar, we often write about how our favorite managers invest with conviction. But how can a manager have conviction in hundreds of tiny positions that make up a portfolio? The main concern with such broad portfolios is that the manager will have a hard time establishing a research edge with such a large number of stocks and also that the manager's best ideas will be diluted by so many tiny positions.

There are other ways to show conviction, however. Just because a manager doesn't make big stock-specific bets, he or she can still bet on sectors, industries, specific fundamental factors, regions, or market cap.

We decided to create a screen to help us find domestic-stock funds that have performed admirably with large baskets of stocks. First, we selected only those with at least 250 stock holdings that posted top-third 10-year trailing returns compared with their respective categories. We also capped the expense ratio at 1.25% annually, and we limited our search to open funds that require an initial investment of $10,000 or less.

A variety of fund categories spanning the small-, mid-, and large-cap asset classes were represented in our results. Here are the actively managed funds that came up as of Aug. 5, 2008:

 American Century Strategic Allocation: Aggressive (TWSAX)
 American Funds Fundamental Investors (ANCFX)
 American Funds Growth Fund of America (AGTHX)
 American Funds Investment Company of America (AIVSX)
 Fidelity New Millennium (FMILX)
 Manning & Napier Pro-Blend Max Term (EXHAX)
 Mutual Shares (MUTHX)
 Royce Opportunity (RYPNX)
 Royce Pennsylvania Mutual (PENNX)
 Royce Total Return (RYTRX)
 T. Rowe Price Personal Strategy Growth (TRSGX)
 T. Rowe Price Small-Cap Value (PRSVX)
 Value Line Emerging Opportunities (VLEOX)
 Vanguard Morgan Growth 
 Vanguard Tax-Managed Capital Appreciation 

When checking the three-year standard deviation of these funds relative to their categories, we found that most of these funds also had below-average volatility. So how have they achieved their strong long-term records?

 Vanguard Morgan Growth  has been successful with its rather unique approach. Two of this fund's four managers use quantitative models that track the Russell Midcap Growth Index and the MSCI U.S. Prime Market Growth Index, while the other two managers actively pick growth stocks for their sleeves of the portfolio. So, the fund's roughly 355 stocks are split into more manageable chunks for each manager. The process has resulted in a 4.3% annualized gain over the past 10 years, which is low in absolute terms, but it beats out the typical growth-oriented peer's return of 2.7%.

Large-blend fund  Manning & Napier Pro-Blend Max Term (EXHAX) is another offering with hundreds of holdings. The secret to its success lies in its team-managed approach. Analysts are assigned to a global industry and have the ability to snap up small caps and large caps wherever they find the best absolute, as opposed to relative, values. The team members funnel ideas into the firm's other offerings, which also have abundant holdings. In addition, the firm has a separate team of economists who provide market forecasts to assist the global analysts. While the fund doesn't take on a lot of stock-specific risk, the global analysts and economists do make significant bets on the sector level. And over the trailing 10-year period the fund has been more volatile (as measured by standard deviation) than most peers. However, its annualized returns of 9.4% for that time period are more than double the typical peer's.

Small-cap investing is an area in which some investors maintain that stock diversification is essential to the strategy. Chuck Royce, manager of  Royce Pennsylvania Mutual (PENNX), is one of them. This small-blend fund, the firm's flagship, holds a healthy dose of micro-cap stocks. Because micro-caps are thinly traded and have relatively short business histories, Royce believes that 500-plus holdings are necessary to win in the space. His price discipline is also embedded in this diversification, as this attention to valuation means he generally won't build positions that move the needle on the firm's stock price. Four comanagers help Royce follow these tiny firms, and the fund has earned roughly 11% annually for the trailing 10-year period.

Morningstar.com Premium Members can run this screen themselves by  clicking here. Not a Premium Member? You can still run this screen by taking a free, 14-day Premium Membership trial. (Note that the results may change as funds come in or drop out of the screen over time.)