The Case for (and Against) Concentrated Funds

Red Menace Earlier this month, GMO led its quarterly letter with the provocatively titled “Don’t Act Like Stalin!,” penned by Ben Inker. Ah, I said to myself, remembering Alliance Bernstein’s white-paper headline, “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism.” Another investment-management article haunted by the specter of Soviet ghosts.

This commentary, however, is solid. (I was less than impressed by Alliance Bernstein's effort.) Of course, its teaser is rather silly. Acting like Stalin, it turns out, is not ignoring reports of German troops gathering on the Russian border. Nor is it chasing women (Stalin being quite the rake in his youth). Rather, it means tasking investment managers with beating inflation by an annualized 4.5 percentage points for the next 10 years, with failure being penalized by death.

Note that under Stalin’s conditions, interim results do not matter. The portfolio manager is judged only once, at the end of the decade. Also unimportant are margins of victory or defeat. By Stalin’s judgment, beating inflation by 2000 basis points per year is the same as doing so by 450—you live. Outgaining inflation by 449 points, however, is no better than losing the entire portfolio. Stalin is unhappy, and you are gone.This, obviously, is an unrealistic mandate (even for Stalin). However, it makes for a useful investment exercise. Replace Stalin’s literal firing squad with the metaphorical firing squad of disappointed investors, and the topic becomes directly relevant: What is the highest-probability path for achieving an ambitious investment goal?

Two Paths One approach is The Vanguard Way. (No trademark necessary; I just made up that phrase.) Allocate to higher-risk, higher-return asset classes; index within each asset class; trade only on occasion; and keep expenses near zero. That strategy requires the stock market's blessing; if global equities don't outpace inflation by several percentage points, the portfolio will almost certainly lose. Should stocks perform well, however, Stalin will be satisfied.

Another approach, addressed by Inker, is obtaining the desired extra return by hiring superior investment managers. That tactic, to be sure, is currently out of favor, particularly with retail fund shareholders. But it may come back in style. Even if not, the lessons that Inker draws are worth considering.

His suggestion for those investing under Stalin conditions: Buy concentrated funds. Probably very concentrated. Mind you, he doesn’t phrase the matter that way. Rather, he writes about hiring managers who have “high tracking error” (institutional-investment speak). However, the upshot is the same. While there are some exceptions, most of the stock funds that have high tracking error—meaning they deviate sharply from the returns of an index—are funds that hold relatively few securities, with relatively high weightings for their top positions.

The Logical Chain Inker's logic is as follows:

1. Assume that over the decade, the stock market will beat inflation by a modest 1.5 annual percentage points. Thus, a fully indexed stock portfolio would lag the Stalin goal by 3 percentage points. To use the investment lingo (which Inker happily does, this being a letter for sophisticated readers), the portfolio needs an alpha of 3%.
2. If you must have 3% alpha, then aim higher! After all, an investment manager that targets 3% alpha (and who has the requisite skill to achieve that ambition) will hit that mark half the time, and fall short half the time. Often, that 50% shortfall rate will be acceptable; after all, many of the misses will still be good results, in the grand scheme of things. But 50% makes for bad odds when the boss is Stalin. Better to shoot for a portfolio alpha above 3%, so that one can survive some of the shortfalls.
3. As written above, targeting a high alpha – Inker suggests 7% (!) – means deviating substantially from a benchmark index, which in turn means holding a concentrated portfolio. The investor who seeks the best chance of reaching an ambitious target, and who has access to investment managers who possess genuine skill, should look for portfolio managers who concentrate their holdings and make bold bets.
4. Those managers should be plural, not singular. Assuming that the results attributable to manager skill are independent, so that one manager's fortunes aren't related to another's (a reasonably sound postulate), then the basic principles of diversification apply. Allocate the portfolio to several concentrated funds, rather than place all eggs into a single basket.

Real-World Caveats To this advice, Inker adds a warning: The good may be undone by performance-chasing. Investors who fire their seemingly unsuccessful concentrated managers, replacing them with recent winners, are likely to harm their returns, probably significantly. Writes Inker, "If you want to hire aggressive, high-tracking-error managers, the key element is ensuring that you do not chase performance like the average institution."

By Inker’s telling, most pension funds have trouble using active investment managers not because such managers cannot deliver benefits, but rather because those pensions have made some poor decisions. “Over the last 15 or 20 years, a number of institutions, particularly some of the large endowments and foundations, have shown they can do well hiring very aggressive managers.” Those organizations avoid performance-chasing—and yes, they also have enjoyed some good luck. (Never discount the effects of fortune.)The lesson for retail investors, I am afraid, is less inspiring. Through some of its hedge funds, private-equity funds, venture-capital funds, buyout funds, and high-minimum long-only funds, the institutional marketplace offers concentrated investment funds that can indeed be expected to outperform the overall stock market. Not always, of course, and certainly not in all years. But enough to assist the savvy institutional investor. For various reasons, that is not so with retail funds. In general, concentrated stock funds do not outperform standard funds.

The case for retail investors using concentrated mutual funds, then, applies in theory but not in practice. This time, the fault is not the fund investors'. It may well be—in fact, probably would be—that fund investors would misuse concentrated funds by performance-chasing, as so many institutional buyers do. However, fund investors do no such things, because they (correctly) avoid concentrated funds. Those funds haven't performed well enough to deserve the assets—and thus the implementation of Inker's suggested strategy.

Perhaps someday.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.