There is a large body of evidence demonstrating that, on average, actively managed funds underperform appropriate risk-adjusted benchmarks. One often-heard excuse for their failure is that the typical fund is "overdiversified"—by owning so many stocks, the value of the manager's best ideas are diluted. Even Warren Buffett seems to agree with that hypothesis. Here is what he has said about diversification: "Wide diversification is only required when investors do not understand what they are doing." 

The mutual fund industry's solution (or sales pitch) to what Buffett called "di-worse-si-fying" portfolios is to create "focus" funds: funds that concentrate the fund's holdings in the manager's best ideas. While most mutual funds hold well over 100 stocks, the typical focus fund will hold 40 or fewer. There are even funds that hire several submanagers for just their single best pick.

The question for investors is: Does concentration of risk improve returns? Travis Sapp (Iowa State University) and Xuemin (Sterling) Yan (University of Missouri-Columbia) sought the answer to that question in their 2008 study, "Security Concentration and Active Fund Management: Do Focused Funds Offer Superior Performance?"¹ Their database covered the period from 1984 through 2002, and contained 2,278 funds comprising 16,399 fund-years. The study excluded funds with fewer than 12 holdings as well as those with less than $1 million in assets. The following is a summary of their findings:

• There was no evidence that focused funds outperform diversified funds. In fact, after controlling for other fund characteristics, funds with a large number of holdings significantly outperformed funds with a small number of holdings both before and after expenses. In other words, fund performance is positively, not negatively, correlated to the number of securities in the portfolio.
• The quintile of funds with the fewest holdings realized an economically and statistically significant annual three-factor alpha (return above benchmark, accounting for the exposure to the risks of the overall market, small stocks and value stocks) of negative 1.44 percent.
• At the one-year horizon, the buys of focused funds underperformed their sells by 0.3 percent.
• Focused funds have significantly higher return volatility and tracking error to benchmarks. Investors were taking greater risk while earning lower returns.
• Focused funds held considerably larger cash positions: 12.8 percent versus 7.8 percent for diversified funds. Cash acts as a drag on returns for equity funds.
• The attrition rate of focused funds is higher than that of diversified funds.

Strategies Don't Have Costs; Implementing Them Does 

One explanation for the underperformance is that the larger the ownership stake in a firm becomes, the greater the trading costs—the fund cannot react quickly to new information without incurring significant market impact costs. As the authors noted, "even if managers of focused funds have better stock-picking ability, their funds might not perform better than diversified funds because of liquidity problems." Once trading costs are added to the burden of their relatively high operating expense ratios, achieving a risk-adjusted alpha becomes difficult.

Another explanation for the failure of focus funds is that the market is sufficiently efficient such that after expenses, it becomes difficult to exploit any pricing errors.

While not all focus funds have delivered poor returns, the following is an example of what can happen when investors concentrate risk.

Hocus Pocus

James D. McCall, manager of the PBHG Large Cap 20 Fund, was one of the shining stars of the mutual fund world in the late 1990s. In the two and a half years McCall ran it, the fund ranked first among its peer group (large growth funds) and provided investors with average annual returns in excess of 50 percent.² Merrill Lynch hired him away to run the Merrill Lynch Focus 20 Fund. The fund was launched to great fanfare in March 2000. At the time, it was the largest IPO ever for a mutual fund, raising over $1 billion from investors. Ultimately, the fund raised over $1.7 billion,⁴ a tribute to the "thundering herd"—Merrill Lynch's marketing machine of stockbrokers. Unfortunately for investors, in 2001, the B shares of the fund (MBFOX) lost 70.4 percent. In 2002, the fund lost a further 40.0 percent, for a cumulative two-year loss of 82 percent.⁵ Those performances earned the fund category percentile rankings of 99 and 97, respectively.⁶ It is worth noting that the fund had an expense ratio of 2.2 percent. As Rex Sinquefield, former co-chairman of Dimensional Fund Advisors noted, "poor performance doesn't come cheap; you have to pay dearly for it." The fund is now called the BlackRock Focus Growth Fund.        

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