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In Focus #70: June 9, 2009


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Concentrated Mutual Funds: Probably Not A Wise Choice


hat do Janus 20, PBHG Large Cap 20, Pimco Value 25, Strong Dow 30 Value, Montgomery Select 50 all have in common? They are among the many concentrated mutual funds. That means that they hold a certain, small number of stocks, typically 20 to 30 in number. Investors usually choose concentrated mutual funds because they have a great degree of faith in the fund's manager. Indeed, the manager's stock-picking prowess absolutely is critical, given that he or she proverbially is "putting all of the eggs in one basket".

Are mutual funds concentrated in such a small number of stocks better than those mutual funds not concentrated? Craig Israelsen, Ph.D., is an associate professor in the department of consumer and family economics at the University of Missouri at Columbia. He examined the data and reported his findings in a recent issue of Financial Planning.

The data was calculated from a sample of 267 large cap, non-index, domestic equity funds, all with at least 10 years of performance data through September, 1999. Israelsen then placed each of the 267 funds into one of four quartiles. The first quartile of funds (25% of the sample) was comprised of mutual funds with the lowest number of stock holdings. The average number of holdings in this first quartile was 41, and the funds held, on average, nearly 45% of the funds' assets in the 10 largest holdings. These were the concentrated mutual funds.

At the other end of the spectrum, mutual funds in the fourth quartile had an average of 215 stocks and held just under 26% of the funds' assets in the 10 largest holdings. These were the non-concentrated mutual funds.

Are concentrated funds a better choice than non-concentrated funds? Israelsen examines this question in several respects, and concludes that they are not a better choice. In sum, concentrated mutual funds provide greater risk (given increased volatility), but without the greater returns.

One area that Israelsen studied was expense ratios. He found that concentrated funds have higher expense ratios (average of 1.31% over last 10 years) than non-concentrated funds (.93%). That is a significant drag on performance. On the other hand, concentrated funds have had an advantage over non-concentrated funds when one considers the funds' turnover ratios. Concentrated funds had a turnover ratio of 70% over the 10 year period compared to 88% for non-concentrated funds. Israelsen believes that the lower percentage for concentrated funds reflects the fund manager's greater commitment to a buy and hold philosophy.

Nonetheless, the most compelling findings in favor of non-concentrated funds are that they have a higher alpha, a higher Sharpe ratio and a lower standard deviation than non-concentrated funds. First, let's examine alpha. Alpha often is used to measure a fund manager's skill. In other words, alpha looks at a fund's actual returns and compares them to the fund's expected returns given the level of risk (measured by beta) that the fund assumes. Here, Israelsen finds an advantage in favor of non-concentrated funds, but gives much of the credit to the continuous Bull Market -- after all, non-concentrated large cap mutual funds tend to track the market as a whole. Accordingly, Israelsen is quick to point out that in a Bear Market or in a less active market, the results easily could be reversed in favor of concentrated funds.

Likewise, the Sharpe ratio favors non-concentrated funds. A higher Sharpe ratio is better. Non-concentrated funds had, over the last 10 years, a Sharpe ratio of .91 versus .76 for concentrated funds.

Finally, standard deviation. Owing again to the fact that one should expect to see greater volatility in a portfolio of 30 stocks that in a portfolio of 200 stocks, non-concentrated funds again do better, because they have had lower standard deviation from their expected returns. Non-concentrated funds had a standard deviation, from their expected returns, of 15.5, compared to 16.9 for concentrated funds.

As of mid-1999, non-concentrated funds had about 7 times more in assets than concentrated funds. Based upon Israelsen's study, it is easy to see why investors have favored non-concentrated funds. But stay tuned. In a different kind of stock market, investors may want to consider playing fewer, rather than more, cards with a stock-picking pro.



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