Blog - Investing Notes
December 5, 2007 - Do Funds
Focused on Just a Few Stocks Outperform?
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?", forthcoming in The Financial
Review, 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.
For related research, see Blog
Synthesis: Mutual Funds and Hedge Funds.
