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Investing Specialists

Is a Concentrated Fund a Fit for Your Portfolio?

Four questions to ask when determining whether a focused holding makes sense for you.

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 Sequoia (SEQUX) recently made headlines for its concentrated portfolio, as a double-digit position in  Valeant Pharmaceuticals (VRX) has led to sizable losses at this storied fund.

But Sequoia is hardly the first concentrated fund to soar, then take a nosedive, due to its heavily weighted positions. Some of the most fabled mutual funds of the past few decades have experienced a similar boom-bust cycle, including  Fairholme (FAIRX),  Oakmark Select I (OAKLX), and  Janus Twenty T (JAVLX). Some have recovered, others not so much.

The Sequoia situation--and the fact that it feels a lot like déjà vu all over again, given previous, well-publicized troubles at other concentrated funds--has many mutual fund investors questioning whether concentrated funds are worth the bother.

Morningstar’s analysts clearly believe that focused strategies can be effective: 14 domestic-equity funds with more than 50% of their assets in their top 10 stocks earn Analyst Ratings of Bronze or better, and there are eight Morningstar Medalist funds with more than 60% of their assets in their top 10 positions.

But even very good focused portfolios aren't right for every investor's portfolio. An investor's time horizon--as well as the related factors of risk tolerance and risk capacity--play a huge role in determining the appropriateness of a concentrated fund. So does the complexion of the total portfolio. Is the concentrated holding appropriately sized? Are other holdings adding to, or taking edge off, the additional volatility that is bound to accompany the concentrated fund?

For investors considering a concentrated fund or wrestling with whether to hang on to it (looking at you, Sequoia holders), here are some key portfolio-related questions to bear in mind.

Do you have an extra-long time horizon?
It goes without saying that anyone owning stocks should have at least a 10-year time horizon; while stocks have a positive return in more than 90% of rolling 10-year periods, they’re a much less reliable source of positive returns over shorter time frames. But concentrated funds arguably need an even longer runway. That’s because company-specific events, rather than the trajectory of the broad market, will tend to be the biggest determinant of their return patterns. Thus, there’s a possibility that a concentrated fund’s portfolio will be at a low ebb at the end of an investor’s holding period, even if he or she has held on to it for 10 years and the broad market’s return is positive over that period.

Here, Sequoia is a great (though perhaps somewhat accidental) case in point. Over the trailing 10-year period, investors would have been better off buying an S&P 500 Index fund and calling it a day. Over the past 15 years, however, even the Sequoia investor who needed to sell at today’s depressed levels would come out ahead of the S&P. The longer the time horizon, the better the odds that a successful concentrated fund’s bets will enhance returns. (Of course, index-fund proponents would argue--quite rightly--that the longer the time horizon, the more likely it is that low-cost, broad-market index trackers will beat out the universe of actively managed funds, owing to the latter group’s cost hurdle.)

Is capitulation a risk?
Another key risk of concentrated funds is what I call the capitulation factor: Even if you have a nice long time horizon until you’ll need to start spending your money (for living expenses in retirement, for example), will you be able to hang on through the periods of weak performance that inevitably accompany concentrated funds?

Assessing your past behavior with other “problem children” in your portfolio can go a long way toward answering this question. Have you sold concentrated holdings in the past when performance has tanked, only to regret the decision? If so, sticking with more diffuse, market-like equity exposure is a better bet. Your portfolio won’t avoid losses at various points in time, but those losses will be in line with those of investors as a group, and therefore may be psychologically easier to bear.

Understanding the concentrated fund’s strategy, as well as management's thinking on its top-weighted positions, can also help keep you in your seat amid performance struggles. Morningstar’s analysts aim to provide a thorough overview of the process and people in place at all funds they cover. Reading a concentrated fund’s shareholder literature can provide additional insights into management's strategy and the rationale for its top-weighted holdings. Of course, it may turn out that you disagree with management's rationale, or you think the fund has begun taking on more risk than you're comfortable with. But it's always better to root your selling decisions in portfolio fundamentals rather than responding to performance alone.

What does the rest of your portfolio look like?
Having a sensible asset allocation framework, including adequate liquidity and exposure to relatively uncorrelated assets like high-quality bonds, is the single best way to reduce the risks associated with a portfolio's equity exposure--concentrated or otherwise. Investors can further tone down the volatility that a concentrated fund introduces by holding it alongside a broad-market equity index fund. Such funds, with top positions maxing out at about 3% of assets, can help smooth out some of the volatility that accompanies a focused portfolio.

It's also worthwhile to assess whether your fund's concentrated positions pop up elsewhere in your portfolio. You may find that other holdings have sizable weightings in those same stocks, exacerbating the risk potential of the concentrated fund. Morningstar's Stock Intersection feature, part of Morningstar's  Portfolio X-Ray functionality in Portfolio Manager, can help you assess whether your total portfolio is extremely top-heavy.

What’s a reasonable position size?
For investors who have decided to make room for a concentrated fund in their portfolios, the next step is to determine how large a position to take. The right position size depends on the investor--based on factors such as time horizon, as outlined above. But it also depends on the fund itself. Morningstar director of fund research Russ Kinnel points out that concentrated funds vary widely in their approaches, ranging from ultra-aggressive funds such as  Morgan Stanley Inst Growth A (MSEGX) to tame offerings such as  Jensen Quality Growth J (JENSX). Because of its aggressive strategy and bold portfolio, the former is best suited to be a "supporting player" in a broadly diversified portfolio, limited to less than 10% of assets. The Jensen fund, meanwhile, could reasonably occupy a larger role. Despite its concentration, the fund maintains a high-quality emphasis and its volatility level, as measured by standard deviation, has generally been lower than the broad market's.

Christine Benz has a position in the following securities mentioned above: OAKLX. Find out about Morningstar’s editorial policies.