Focused Funds Hold Their Own in the Market Turmoil

Without a doubt, concentrated funds can be a double-edged sword for both their managers and fund shareholders. Pick the right stocks, and returns soar, money flows in, and life is great. Stumble with a few of your picks, and just the opposite occurs, as there are fewer holdings to cushion the blow and returns can sink in a hurry. Concentrated funds by their very construction tend to be more volatile, as the fund's fortunes are determined by a limited investment set.

Given concentrated funds' higher risk profile, it stands to reason that fund companies wouldn't let just anyone run a concentrated fund. Often the firm's best stock-pickers run such gutsy offerings, so it's not unreasonable to expect them to hold up better than most during times of stress. To test this theory, we examined concentrated funds' performance during both the recent market turbulence as well as over the long term to see if they fared better than the competition.

Our Criteria
We looked at total returns for funds with 50 or fewer stocks that resided in the nine domestic-equity categories that together represent the Morningstar Style Box. To hone in on the true actively managed domestic funds, we excluded index funds as well as funds of funds. We also limited the universe to those funds that were in existence at the start of 2008. There are approximately 2,840 distinct funds within the nine diversified domestic-equity categories, and 580 of them passed our "concentration" criteria, with the majority residing in Morningstar's large-cap categories.

The Results
To determine how well concentrated funds fared in the recent market slide, we examined the funds' trailing returns for the past eight weeks as well as for the year to date through Nov. 7, 2008. As anyone who has looked at their account statement knows, the last two months have been absolutely brutal.  Fidelity Spartan Total Stock Market Index   (an investible proxy for the entire U.S. stock market) lost 26.4% over that time frame and is down 35.6% for the year-to-date period.

On average, the concentrated funds held their ground versus their peers and the broad market. As the table below shows, the returns for each category subset of focused funds were virtually equal to those of its broader group and were in line with the U.S. market for both the past eight weeks and over the course of 2008.

Concentrated Funds by Category
	Past 8 Weeks (%)	YTD Return (%)	5-Year Return* (%)	10-Year Return* (%)
Fidelity Spartan Total Market Index	-26.35	-35.59	-0.25	0.34
Concentrated Large-Blend Funds Large-Blend Category	-26.16 -25.83	-35.37 -36.31	-1.00 -1.15	1.69 0.12
Concentrated Large-Growth Funds Large-Growth Category	-26.76 -27.33	-37.77 -38.83	-1.49 -2.12	0.13 -0.99
Concentrated Large-Value Funds Large-Value Category	-25.98 -25.36	-36.02 -36.09	-0.32 -0.29	1.71 1.31
Concentrated Mid-Cap Blend Funds Mid-Cap Blend Category	-29.62 -30.99	-37.11 -38.66	-0.42 -0.90	4.18 3.72
Concentrated Mid-Cap Growth Funds Mid-Cap Growth Category	-28.28 -31.17	-38.95 -42.22	-0.70 -1.64	2.31 2.19
Concentrated Mid-Cap Value Funds Mid-Cap Value Category	-29.91 -30.23	-35.14 -36.73	1.66 -0.01	5.70 5.47
Concentrated Small-Blend Funds Small-Blend Category	-30.83 -30.36	-36.63 -35.91	0.15 -0.65	6.68 4.76
Concentrated Small-Growth Funds Small-Growth Category	-28.58 -30.15	-40.34 -40.54	-5.58 -2.83	-0.32 2.93
Concentrated Small-Value Funds Small-Value Category	-29.57 -29.12	-33.69 -31.78	-0.35 0.13	4.50 5.90
* Returns are annualized.

Our subset of concentrated managers got a few things right. For one, they're holding more cash on average compared with their broader category peers, according to the most-recent holdings disclosures. In the best-case scenario, the funds were holding a larger cash stake all year. But even if the cash has been building, it still likely helped cushion returns during the market downturn, particularly during October, when the index fund dropped 17.6%. The concentrated funds currently have, on average, between 5% and 9% of assets sitting in cash, while the typical actively managed fund has a cash stake of 2%-4% of assets.

It's also interesting that focused large-cap funds typically held more assets in financials than the respective broader category, yet kept pace on a total return basis. That could be a sign of good stock-picking, but the funds were likely also helped by higher stakes in consumer goods, which tend to be more defensive, as well as smaller stakes in the energy sector, which has struggled mightily over the past several months. Within the mid- and small-cap subsets, allocation across the same three sectors appears to have been a plus.

Asset-Allocation Highlights
	Cash (%)	Financials (%)	Con. Goods (%)	Energy (%)
Concentrated Large-Blend Funds Large-Blend Category	5.19 2.06	16.39 15.40	10.11 9.16	11.09 14.71
Concentrated Large-Growth Funds Large-Growth Category	5.11 4.39	11.44 8.75	6.82 6.70	9.23 13.64
Concentrated Large-Value Funds Large-Value Category	5.54 3.27	20.08 18.88	11.51 9.87	12.01 14.51
Concentrated Mid-Cap Blend Funds Mid-Cap Blend Category	6.10 4.12	15.25 14.27	9.52 7.33	8.14 13.61
Concentrated Mid-Cap Growth Funds Mid-Cap Growth Category	5.64 3.54	7.80 8.45	5.86 5.66	7.33 12.80
Concentrated Mid-Cap Value Funds Mid-Cap Value Category	9.63 4.30	17.67 20.65	12.88 10.23	8.59 10.30
Concentrated Small-Blend Funds Small-Blend Category	5.96 3.81	10.98 15.35	7.37 6.49	11.08 10.28
Concentrated Small-Growth Funds Small-Growth Category	7.66 3.81	5.72 7.11	5.57 5.46	5.22 10.21
Concentrated Small-Value Funds Small-Value Category	11.30 4.45	19.86 23.38	8.48 7.84	8.56 8.37

But within these larger trends there have been big winners--and losers--among focused offerings. For example, Fund Analyst Pick  Fairholme Fund's (FAIRX) 27% loss is meaningfully better than the market's setback, thanks to a sizeable cash stake and a timely rotation out of energy stocks, while Bill Miller's  Legg Mason Value (LMVTX) has seen returns fall more than 53% as several of its top picks have dropped more than 50% for the year to date.

Meanwhile, fast-trading  CGM Focus  also got its hand stuck in the cookie jar this year with a sizeable stake in industrial and energy names such as  Weatherford International  and  U.S. Steel (X) as of June 30. Its 43% loss is painful, yet its long-term returns still rank among the large-blend category's elite. Others have less to be proud of, including Oberweis Mid-Cap , which has been a consistent dog (even before 2008), despite a nimble asset base of just $5 million. According to the fund's most-recent portfolio, business-service picks appear to be the culprit this year, and the 1.80% expense ratio surely isn't helping things either.

Short-term returns can provide shareholders with an important gut-check, but more telling are a fund's longer-term returns. Although the funds as a whole weren't standouts during the market's swoon in 2008, their compact profiles and greater perceived risk have delivered over time. Concentrated funds in seven of the nine categories we examined have beaten the broad market over the past 10 years (the exceptions were focused large-growth and small-growth offerings), while all the concentrated peer groups save small growth and small value outpaced their broader category averages.

Other Takeaways
No fund is going to be all things all the time. A baseball player that hits .333 likely gets into the Hall of Fame, but that doesn't mean that he consistently got one hit every third at-bat. Likewise, concentrated funds don't make spot-on calls 100% of the time, but successful managers typically pick more winners on a consistent basis to offset their missteps.

Given concentrated funds' long-term success, investors should be willing to stick with them through the darker times. Understanding what a fund will--and won't--do will help investors feel secure during periods when the offering's focused approach may be out of style. Concentrated funds certainly make a strong case for long-term holdings. Investors are paying for, and getting, active-management returns in most cases.