Do Fewer Stocks Make Better Funds?

Here's the theory: A fund manager who ignores all but his 'best' ideas should outperform. In practice, it's not so simple.

Michael Stout has some advice for mutual-fund investors: "Concentrate with care."

The senior analyst at Morningstar isn't talking about a mental exercise. He's referring to the desire of some investors to pick mutual funds that hold relatively few stocks.

The thesis is that managers of focused funds will select only the best of their investment ideas. Ordinary logic suggests this might produce better performance.

And in fact, some of these managers do have strong records.

Jeffrey Poppenhagen turned in a 36 percent gain for 1997 (through Dec. 29) with the 32 stocks held in Pioneer Growth Shares, for example.

"I don't feel very comfortable running stock in 200, 225 companies," he says. "Thirty stocks is all the businesses I can understand."

But Morningstar, a Chicago firm that researches mutual funds, has found that focused funds in general haven't produced superior returns.

"Whether one looked at the three-, five-, or 15-year periods ... fund returns did not improve systematically as the number of holdings decreased," Mr. Stout writes in a Morningstar study. "In fact, they got a little worse."

Targeting fewer stocks "increases the price volatility of the shares without increasing the return," he concludes. Unforeseen good or bad corporate news can have a big impact on a concentrated portfolio.

All this doesn't mean you shouldn't own one of the 217 US equity funds that hold 40 or fewer stocks.

But look for a manager who is "one heck of a stock picker," Stout says. And don't view concentration as a panacea for the high volatility in today's market.

A case in point is American Heritage. In the far-right chart, it's listed as 1997's top-performing mutual fund. One reason: Half the fund's assets are in a British medical company that had a good year.

But American Heritage's 75 percent gain last year was balanced by equal losses in the three prior years, taken together. That put it in the bottom 20 percent of all funds for the past five years.

What focused funds make Stout's A list?

He mentions such funds as Sequoia, Clipper, Janus Twenty, and Longleaf Partners.

Another fund he likes, CGM Capital Development (800-345-4048), is closed to new investors, but the firm recently opened a new CGM Focus Fund for investors who like concentration.

Similar funds have sprung up at other well-regarded families - Yacktman Focused (800-525-8258) is one example - responding to growing demand.

Investors are intrigued in part because many mainstream funds have become more and more unwieldy. The typical US stock fund has 127 holdings, and many have double or triple that.

Stout says some widely diversified funds have done better than average by emphasizing a favorite few stocks .

But whether focused or not, managed funds have a hard time beating stock indexes.

In the first half of 1997, just 1 fund in 4 equaled or beat the S&P 500.

That ratio improves when small stocks - those not represented in the S&P 500 - are hot, notes H. Bradlee Perry, a consultant to David L. Babson & Co., a Cambridge, Mass., money manager.

A fund related to the company, Babson Value, has succeeded by focusing on 40 stocks, selected using a complex formula. Once picked, each stock gets an equal share of the portfolio.

The fund has beaten the S&P 500 over a five-year period, notes manager Roland Whitridge.

And Fortune magazine gave the fund top honors in the growth-and-income category for that period, factoring in low taxes (slow turnover of the portfolio reduces capital gains) and expenses.

Pioneer Growth also tries to keep turnover low, creating a "very efficient tax strategy," Mr. Poppenhagen says.

He looks for stocks with solid growth and a "dominant business franchise." As of Sept. 30, top holdings included Dell Computer, Monsanto, Intel, Microsoft, Coca-Cola, and Wrigley.

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