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Focused funds at bargain prices
Some historically hot 'focused' mutual funds have struggled recently and fallen out of favor. The best are likely to bounce back fast.
By Timothy Middleton
Nearly every investor is wrong some of the time. But sometimes the investors most spectacularly wrong are those with the most spectacular records. This perverse phenomenon is happening right now with so-called focused mutual funds, and it can teach you a thing or two about the perils of long-term investing.
In recent years, five of the seven largest of these funds, which typically own about two dozen stocks (as opposed to the 100 or more stocks held by many funds), have gone from leading their categories to barely holding on.
While its uncommon for so many to fall from grace at the same time, it is not uncommon for the most farsighted investors to be way out of sync with the current market mood. The shrewdest investors often make the most money buying unpopular stocks, and sometimes Wall Street catches up later rather than sooner. That lag can put a crimp in a fund's performance.
The effect is amplified as the bets become fewer and bigger. Concentrated portfolios can be great in the best of times and they can be terrible in the worst of times, says Alexander N. Feick, managing director of Paragon Capital Management, an investment advisory firm in Denver. Youve got to accept the risk from that.
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Actually, you dont. Long-term investing doesnt mean putting your funds into a lockbox and throwing away the key. Even savvy investors who stick with these streaky funds through thick and thin only do so if managers hew closely to the discipline they have always used. At the first sign of change, they drop concentrated funds as quickly as Tom DeLay dropped Jack Abramoff.
Some smart investors use these funds opportunistically, dipping in and out of them as if they were sector funds, to be owned only so long as conditions are favorable.
Focused funds are certainly not all-weather funds, says Daniel Sexton, an investment adviser with RS Crum Inc. of Newport Beach, Calif. He suggests selling the funds after periods in which they outperform the market.
It also makes sense to buy when the funds have lagged. In the coming year we are adding a significant amount of our clients money to Oakmark Select (OAKLX), Longleaf Partners (LLPFX) and the Legg Mason Opportunity Fund (LMOPX), says Steven M. Rog, a fund manager with RW Rog & Co. of Bohemia, N.Y.
Focused on sectors
Focused funds became popular during the bull market of the 1990s, when individual mutual-fund managers began to get rock-star attention. In the bear market, the mood went the other way. Investors deserted them in droves.
Today only seven of these funds have both outstanding long-term records and at least $1 billion in assets.
| Focused funds lose focus | | Key funds and their percentile rank in category | 1 year | 3 years | 5 years | 10 years | | Longleaf Partners (LLPFX) | 80 | 38 | 2 | 4 | | Clipper (CFIMX) | 98 | 99 | 23 | 3 | | Oakmark Select I (OAKLX) | 76 | 74 | 4 | n/a | | Marsico Focus (MFOCX) | 13 | 18 | 10 | n/a | | TCW Galileo Sel Equity I (TGCEX) | 42 | 4 | 18 | 7 | | Jensen J (JENSX) | 96 | 97 | 18 | 8 | | CGM Focus (CGMFX) | 2 | 5 | 1 | n/a |
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Notes: Largest equity funds with holdings of between 15 and 30 names. Percentile rank in Morningstar category, where 1=best, 100=worst, n/a = not applicable; fund lacks 10-year record. Numbers as of 11/30/2005.
Source: Morningstar Inc.
While managers of such funds insist that they pick stocks on the basis of individual merit, in reality they usually find their best ideas concentrated in specific industries or sectors. Indeed, says Dan Danford, president of Family Investment Center in St. Joseph, Mo., Id speculate that much of their performance, both good and bad, is sector-related, instead of management genius.
CGM Focus (CGMFX), the focused fund with the most consistent record, has nearly 50% of assets in energy stocks. All of the funds that are in the dumps right now own little or no energy, instead bulking up on such sectors as media (Longleaf), financials (Clipper), business services (Oakmark and Jensen) and technology (TCW Galileo).
Few investors hold sectors as core long-term positions. I own technology and energy funds that I purchased in 2004; all my other sector bets have been sold, most of them long ago. So looking at focused funds as if they were sector funds, to be traded rather than sealed in amber, appeals to many investors.
The best time to buy sectors is when they are out of favor, and by that logic most of the funds in the table above are strong buys because their recent performance has been so poor. Now that Oakmark Select has reopened to new investors, having been closed for most of the last five years, we are backing up the proverbial truck, Rog says.
Of course, for this strategy to work youve got to expect the funds to revive, and thats not automatic. When I queried a group of financial advisers recently about Clipper Fund, whose famed managers left it at the end of last year, all of the advisers who had owned the fund had sold it.
When Clippers team left, so did the investment discipline they had put in place, says George Paquin, an adviser in Chelmsford, Mass. New managers introduce uncertainty, which means risk, and this is a risk easily avoided by simply moving to another fund.
A question of timing
The hazard of trading focused funds, rather than owning them continuously, is that youll misjudge when to buy and sell them. Academic research has shown that even professional investors are poor market timers, implying that amateurs have even less chance of success.
And assuming nothing at the fund has changed except its popularity, the argument in favor of buying and holding is very powerful. Tweedy Browne & Co. has done research showing that in the period 1975 through 2000, only 79 mutual funds beat the market, but 30 of them managed to do it despite trailing badly in more than 13 of those 26 years.
The lesson you draw from this is to stick with it, says John D. Spears, a managing director. In order to do so, however, he admits: You have to have some conviction about the process -- about the theory the manager is practicing. If youre just looking at year-by-year results to gauge future outcomes, youre going to give up.
I know from experience that I dont have that kind of fortitude. I used to own Yacktman Focused Fund (YAFFX), which owns 31 names, but I sold it in 1999 when it went down 22% while the market was soaring more than 20%.
What an idiot. In the five years since then, the fund has delivered annualized returns of 13.8%, beating the market by 13.2 percentage points a year. Whats more, I should have known Don Yacktmans value style of investing would do poorly in a bull market like 1999, and would look spectacular in a bear market, which weve had ever since.
By the way: Yacktmans fund, which is not on the table above because it has less than $100 million in assets, has fallen from the No. 1 performance percentile over five years to No. 97 in the last year. Its on sale, too.
At the time of publication Timothy Middleton didnt own any securities mentioned in this article.
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