Some funds are doomed before they invest a single dollar.
Franklin Double Tax-Free Income (FPRTX) , highlighted here last month, was designed in a way that forced the managers to own a limited number of securities whose price movements were bound to be highly correlated: municipal bonds issued in Puerto Rico and a few other overseas American territories that are nice places to visit, but you wouldn’t want to invest there. At least not there and nowhere else.
Franklin Double Tax-Free Income, thankfully, seems unique. Analysts at S&P Capital IQ and investment researcher Morningstar were unaware of any other fund that was so heavily weighted to such a narrow range of securities.
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Not every fund is meant to be diversified. Some muni portfolios exist to hold bonds issued in a single state, for instance. Biotechnology funds are likely to own nothing but biotech stocks, gold-mining funds will own shares of gold miners, and so on.
Fair enough. Shareholders know what they’re getting, and it’s up to them to achieve proper diversification by mixing those funds with others. But there are plenty of funds that are thought to be broadly diversified yet have such heavy allocations to narrow niches that they hardly can be considered diversified at all.
An analysis for MarketWatch by Morningstar found 16 ostensibly broad-based domestic-equity funds that as of their last reporting date had more than half of their assets in just one of the 10 sectors into which Standard & Poor’s divides the stock market. Three had exposure exceeding 60% in a single sector: Fairholme /zigman2/quotes/200889155/realtime FAIRX -0.97% , Needham Aggressive Growth /zigman2/quotes/205686828/realtime NEAGX -1.09% and Nationwide Small Company Growth /zigman2/quotes/209564506/realtime NWSAX -2.32% .
Fairholme was 68% invested in financial stocks, as of May 31. The Needham and Nationwide portfolios had their 60%-plus allocations to technology on June 30 and July 31, respectively.
The 13 funds that had 50% to 60% in one sector were hard to pigeonhole. Specialists in small-, medium- and large companies were represented; seven are growth funds, with the others tilted toward value or not at all. As for the overweight sectors, it was an eclectic mix of tech, health care, utilities, industrials, consumer defensive and consumer cyclical.
It’s unclear whether the managers make big bets routinely or just occasionally. In either case, several of the funds are conspicuously volatile, beating the competition for a while and then having the field catch up to them. A spectacular example of this is CGM Focus /zigman2/quotes/203752257/realtime CGMFX -1.91% , which has been heavily invested in consumer cyclicals.
CGM Focus soared about 250% between mid-2004 and mid-2008, then collapsed during the financial crisis and has underperformed since. That helps to explain why Morningstar awards it its worst rating, one star, based on three-year risk-adjusted returns.
Another fund, Biondo Focus /zigman2/quotes/200509704/realtime BFONX -1.79% , whose big allocation is to health care, gets one star mainly due to a dismal run through 2012. It has been catching up lately by being more than 22% invested in a single industry, biotechnology. Biotech stocks are notoriously volatile, however, so unless the managers get lucky or good and sell before the group rolls over, their relative returns could slide again.
Two of the funds with heavy bets on the tech sector get five-star ratings: Fidelity OTC Portfolio /zigman2/quotes/205988730/realtime FOCPX -1.07% and Brown Capital Management Small Companies /zigman2/quotes/205997173/realtime BCSIX -2.22% . The Brown Capital fund has been steadily outpacing other smaller-company growth funds since the financial crisis and the resulting bear market, while the Fidelity fund has done the same in the large-capitalization-growth category.
The 16 funds taken together have returns and ratings in line with the broad market. It might seem, based on such performance, that there’s no great harm in loading up on a single corner of the market. But stocks are in a strong bull market and 13 of the 16 funds made their big allocations to sectors that tend to beat the market on the way up and do worse when the trend reverses. That could make many of these funds, and others with sector bets that are more modest but still large, underperform substantially in the next correction or bear market.
If you want to focus on stocks in a particular sector — or industry or country or bonds of a certain average maturity or credit quality — you’ll probably assume less risk by concentrating on portfolios that are broadly diversified for real. To discover how diversified a fund you’re considering is, go to the website of a data provider like Morningstar and compare the asset allocation to the average for its peer group.
Once you have the core of your portfolio sorted out, you can add modest investments in funds that explicitly focus on whichever narrow niches you choose to emphasize. That way, you can be exposed to them in the proportions you want, rather than be hostage to market momentum and managers’ whims.