Do the most skilled stock pickers among fund managers gravitate toward funds that focus on a few good ideas, thereby outperforming diversified peers? In their recent paper entitled “Security Concentration and Active Fund Management: Do Focused Funds Offer Superior Performance?”, Travis Sapp and Xuemin Yan examine whether funds concentrated in relatively few securities outperform. Using price and holdings data for a broad sample of U.S. equity mutual funds operating at any time during 1984-2002 (2,278 funds encompassing 16,399 fund-years), they conclude that:
- The 20% of funds that are most focused hold only 29 stocks on average and tend to be small and young, with high expense ratios and large cash balances. They tend more toward large growth stocks than their less focused peers.
- Fund performance relates positively to number of holdings, with superior performance associated with both high industry concentration and a large number of holdings.
- Based on raw returns, focused funds underperform diversified funds by an insignificant 0.07% (0.10%) per month before (after) expenses. Adjusting for market, size and value factors, focused funds generate an economically and statistically significant annual alpha of -1.44% after expenses. In contrast, performance of the most diversified funds does not significantly differ from benchmarks before or after expenses.
- At the one-year horizon, the buys of focused funds underperform their sells by 0.3%, while the buys of diversified funds outperform sells by 0.35%.
- The attrition rate of focused funds is higher than that of diversified funds.
- Focused (diversified) funds have negative (positive) exposure to the momentum factor. Higher fees and negative momentum exposure explain much of the underperformance of focused funds.
- Focused fund portfolios tend to have low liquidity, inhibiting timely response to new information without substantial price impact.
- Focused funds tend to be volatile, consistent with a scenario of low-skill managers attempting to attract investors by holding concentrated, risky portfolios.
In summary, mutual funds with relatively few holdings tend to underperform, refuting the view that focus on a few ideas supports good stock picking.
