I’ve seen some great concentrated funds and many terrible ones, which is inevitable as both the opportunities and risks increase with concentration. But I do sometimes wonder at the marketing of these funds. Invariably I hear/see things like “these are our best ideas” and why would you put money into your 30th best stock instead of your first?
But I often wonder if the marketing of some of these funds isn’t terrific spin to make what is really a drawback appear to be a strength. The drawbacks could be in some cases limited research capacity, intellectual laziness, overconfidence and a lack of imagination. In other words, there are literally thousands of stocks to investigate and consider, but this fund manager thinks there are only 20 or 30 worth considering. They may actually not think that but be unwilling to admit they only have two or three analysts and simply don’t have the resources to cover other companies. They also may want to swing for the fences with just a handful of stocks hoping to have a big year to draw your assets and hey it’s not their money but yours at risk.
It is often boutique managers running these concentrated funds. I’ve seen a handful that have also been really good at risk control, and it’s impressive and important to pay attention to. But I think it’s worth noting that there are managers who do have the resources to cover thousands of stocks. Fidelity’s 100th best idea may prove better than the boutique manager’s twentieth or even first. At the least, their hundredth will expose their investors to less unique potentially devastating business risk than a concentrated fund’s.
Most of the funds where I have found concentration has worked best are those that focus on a unique factor--quality. They invest in dominant businesses with strong balance sheets and reliable cash flows. That insulates the portfolio from idiosyncratic business risk. They also don't overpay for these companies. Yacktman and Jensen come to mind. Yet a number of other strategies I've seen backfire in concentrated styles--deep value in distressed companies, aggressive growth in unproven story stocks and small or microcap stocks where the companies only have one line of business.
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The other issue is that even successful concentrated funds can be volatile with big upswings and downturns. That the research indicates can lead to poor "investor returns" in that investors are terrible trading such funds, buying them at their peaks and selling them at the bottoms. So, even if a concentrated fund is good, investors may not enjoy the good times in it. That's why I think with concentrated funds it's essential for all but the savviest traders who can time their purchases well to study the fund's risk stats and seek out the concentrated fund with good downside protection and lower volatility overall--generally the high quality focused funds.