Focused Foreign Funds Are in an Exclusive Club

Just over one third of actively managed domestic core funds held fewer than 50 stocks recently. And it's not uncommon to see 40% to 50% of assets residing in the top 10 holdings in these portfolios. But it's not so easy to find such concentration in international-equity portfolios.

Only about 6% of the 399 foreign large-cap strategies held fewer than 50 stocks at last count. What's more, the median number of holdings for foreign large-cap funds clocked in at 115; that's 51% more stocks than are typically found in a domestic-stock fund. As far as foreign core funds go, it's fair to say that even those with holdings in the 50 to 70 range are on the concentrated side.

Risk and Reward
Some investors are more concerned about volatility in their international funds due to currency risk, emerging-markets exposure, or other factors. So less-volatile foreign funds are all the more appealing. Should investors therefore ignore the more-focused options for those that spread risk over hundreds of smaller positions?

Not necessarily. Take, for example, a test group of all foreign large-cap funds that have at least one manager with a record of 10 years or longer. (This helps ensure that the strategies have been consistent.) This results in 90 distinct strategies, of which roughly 23% held fewer than 75 stocks. (By international-fund standards, that qualifies as relatively focused.) When comparing five- and 10-year standard deviation measures for both the focused and more diffuse sets of portfolios, the focused funds actually looked a hare better on this volatility measure.

However, the focused bunch did not fare as well on Morningstar Risk, which is an annualized measure of a fund's downside volatility compared with its peers over various time periods. Only about 19% of the focused funds scored a Morningstar Risk rating of average or better over the trailing 10-year period, whereas just less than 50% of the diffuse portfolios registered 10-year Morningstar Risk ratings of average or better.

So focused funds have in general provided weaker performance on the downside, but overall they outshone their less-focused counterparts on performance. Roughly 60% of the focused funds in this subset landed in the top quartile of all foreign large-cap offerings in the past 10 years. Only about 30% of the more diffuse portfolios achieved that status.

And managers who run concentrated foreign funds certainly aren't doomed to fail at downside protection. A little bit of digging reveals some successful concentrated funds that have kept a lid on risk through a combination of in-depth stock research, deft security selection, and valuation discipline.

Smooth Operators
Talk about focused.  Longleaf Partners International (LLINX) has sported a compact portfolio of fewer than 30 names for years. Managers Mason Hawkins and Staley Cates and their comanagers of Southeastern Asset Management are hard-core value investors, looking for firms that are trading at 40% discounts or more to their intrinsic value estimates. They aren't afraid to go after more cyclical stocks that many value hounds wouldn't touch with a stick. They pay no heed to indexes, and so this portfolio typically has a unique look in terms of its industry and regional weightings. Their low-turnover, valuation-sensitive approach has led to some bottom-decile showings in more exuberant markets, but it has held up relatively well in downdrafts, which has contributed to its great risk/reward profile.

Over the past decade, the management team behind  Manning & Napier World Opportunities  has steered it to success without excessive turbulence. In fact, it suffered 15% less in down periods than the MSCI EAFE Index while delivering just as much in up periods. The managers have the flexibility to hunt across the market-cap spectrum, and they scoop up stocks that they believe are trading at more than a 25% discount to fair value. The portfolio isn't as concentrated as it was a decade ago due to a spike in inflows in recent years, but they've shown that they can still pick plenty of winners in a portfolio of 60 to 70 stocks.

It's been steady as she goes at  MFS Institutional International Equity (MIEIX) during the past 10 years. Manager Marcus Smith, who is the fund's longest-tenured comanager, has done a fine job running a portfolio of roughly 55 to 75 names. And he uses the same low-turnover approach at  USAA International (USIFX), which he and comanager Daniel Ling have been running for more than eight years. Because they are fairly diligent on valuations and price targets, the portfolio tends to have modest price multiples compared with its foreign large-growth peers. Their general avoidance of smaller-caps and emerging-markets stocks also adds to this fund's conservatism and has held it back during more speculative markets.

 Thornburg International Value (TGVAX) has also provided a smoother ride than most of its rivals. And like the MFS fund, it tends to have its best relative showings in down markets. Longtime manager Bill Fries and comanagers Wendy Trevisani and Lei Wang scout out an eclectic mix of stocks for this portfolio. These include financially sound firms selling below their earnings power or net assets, rapidly growing companies that are gaining share within their industries, and blue-chip growth stocks trading at a discount. Their go-anywhere approach means that the portfolio of around 60 stocks often has distinctive sector and country weightings, including a relatively large stake in emerging-markets stocks.