Most mutual funds stay broadly diversified, holding more than 100 stocks. So if a few stocks blow up, the funds may still deliver competitive returns.
But some funds take a bolder approach. These concentrated portfolios own fewer than 50 holdings. The aim is to place big bets on a few stocks. If the choices prove correct, the concentrated funds can rocket to the top of the standings. Of course, the strategy comes with risk. Plenty of concentrated funds suffer big losses.
Should you avoid concentrated funds? Not necessarily. Some top performers proved their worth during the downturns of recent years.
Consider Forester Value Fund, which won a place in the record books when markets collapsed in 2008. Of the more 4,500 domestic equity funds, Forester was the only one to make money for the year, according to fund tracker Morningstar, Inc. Portfolio manager Tom Forester achieved the winning results by deftly maneuvering a concentrated portfolio that included 40 stocks. As the credit crisis unfolded, Forester turned defensive, focusing on high-quality companies such as 3M and Microsoft. Those rock-solid blue chips proved relatively resilient during the downturn.
“When conditions looked extremely hazardous, we turned to the safest assets,” Forester says.
As Forester’s showing demonstrated, concentrated funds can help investors to protect their nest eggs. But keep in mind that concentrated funds can be volatile. Funds can soar one year and lag the next. All too often investors buy concentrated funds after they have recorded a hot streak. When the funds inevitably turn cold, frustrated investors sell. That is a recipe for underperforming the markets.
To get solid results from a concentrated fund, pick one with a strong long-term record. And then hold on for years, waiting out those periods when results may be disappointing. Keep in mind that many concentrated funds follow predictable patterns. By studying past performance, you may be prepared to weather difficult conditions when they appear.
For example, Forester has long excelled in downturns and lagged in bull markets. In 2002, a year when the S&P 500 lost 22%, Forester returned 5.7% and outdid 99% of domestic equity funds. The fund finished near the bottom of the standings in 2006, a year when the S&P 500 returned 16%.
Like Forester, some concentrated funds do especially well in downturns. Top choices for hard times include Osterweis Fund and Yacktman Focused. Diehard value investors, these funds buy solid companies selling at low prices—the kind of stocks that hold up during downturns.
In contrast, some concentrated funds lead in bull markets and trail in downturns. This group includes CGM Focus and Janus Twenty, funds that specialize in stocks with relatively high prices and growing earnings. Such growth stocks often do best during periods when the economy and stock markets boom.
During most years, the results of growth and value concentrated funds diverge widely. In 2007, Janus Twenty returned 35.9% and outdid 99% of its large growth competitors. In the same year, Forester lost 5.2% and lagged 89% of its large value peers. While Forester stayed in the black during 2008, Janus Twenty lost 42.0%.
Lately the funds have been running true to form. With many growth stocks rising, Janus Twenty returned 19.4% during the first five months of 2009, beating the S&P 500 by 16 percentage points. Meanwhile, Forester returned 2.0% and lagged the S&P.
Investors seeking a fund that leads during bear markets should consider Yacktman Focused. The fund outdid more than 98% of its competitors during the downturns of 2008 and 2002. Portfolio manager Donald Yacktman limits losses by holding about 30 solid companies that sell at modest prices. Yacktman prefers companies with steady cash flows and strong market niches. Recent holdings include Coca-Cola and PepsiCo. Yacktman figures that the beverage companies produce reliable sales, even during recessions.
When the markets are climbing, such steady stocks often lose favor on Wall Street. With the economy booming, investors can turn their backs on safe blue chips and race to buy riskier small stocks. That happened in 2005 when Yacktman trailed 98% of his competitors. But over long periods of time, Yacktman’s approach produces dividends. During the past decade, the fund has returned 6.7% annually, beating the S&P 500 by 8.5 percentage points and topping 99% of competitors.
Another fund that seeks to limit losses in downturns is Osterweis, which typically owns about 30 stocks. When stocks decline, portfolio manager John Osterweis often takes dramatic steps to protect his shareholders. With mortgage markets in turmoil last fall, Osterweis sold some financial stocks and shifted a third of his assets to cash. That caution helped him limit losses and outdo most competitors last year. During the past 10 years, the fund has returned 5.8% annually, outdoing the S&P 500 by 7.5 percentage points.
Osterweis prefers undervalued companies with strong balance sheets. Many holdings are recording weak sales, and investors expect the businesses to languish for some time. Osterweis buys when he thinks a company is poised to rebound and surprise Wall Street.
A favorite holding is NV Energy, a power producer in Nevada. The shares sank as investors feared that mortgage defaults would hurt Nevada’s economy and reduce demand for power. But Osterweis says that the company remains sound. “Investors seem to believe that a big number of people are going to leave Nevada, but that is not going to happen,” Osterweis says.
Another holding is Unilever. The maker of Lipton tea and other consumer products has suffered from weak profit margins. But the balance sheet remains strong, and the company is moving to cut costs and boost earnings. Osterweis figures that Unilever can grow, even during the recession. Such solid stocks could enable Osterweis to protect shareholders in downturns and profit when the economy finally recovers.