Concentrated Mutual Funds: Leaving Too Much to Luck

The International Monetary Fund had raised caution back in September, on US mutual funds with large positions in high-yielding bonds that are issued by risky companies in the country or in emerging economies. To tap the low-rate environment, many mutual funds had stacked up these high-risk securities. What this also indicates is a risk of concentrated holdings. While we are well acquainted with the benefits of having a diversified portfolio, investors must also note that mutual funds with a concentrated portfolio offer plenty of risks.

The latest example of a mutual fund fiasco due to a concentrated exposure takes us back to the Valeant Pharmaceuticals stock, which has seen a freefall since after mid September. Eventually, Sequoia Fund (SEQUX) that has nearly 30% of its assets invested in Valeant suffered a nosedive. While this is one example, data from Thomson Reuters' Lipper show that 13 other US equity funds (having over $1 billion worth of assets) have over 10% exposure to a single stock.

Valeant’s Loss Drags SEQUX Down

Valeant’s stock nosedived after it increased the price of two drugs (Nitropress and Isuprel) in Sep 2015. Since Sep 18, Valeant has slumped nearly 70%. Better-than-expected third-quarter earnings failed to halt the plunge, as allegations of debatable transactions with specialty pharmacies surfaced. Investors questioned the accounting and business practices of Valeant, in particular its relationship with specialty pharmacies.

Valeant had issued a press release defending the accusations on its financial reporting and operations. The company clarified in its statement that it does not draw sales benefit from any inventory held at these specialty pharmacies. Valeant emphasized that its revenue recognition policy and accounting plan are in compliance with the law.

However, these efforts were wasted as Valeant shares continued to decline even after a presentation in favor of the company by Bill Ackman, Chief Executive of Pershing Square Capital Management. Incidentally, Ackman is also the third-largest shareholder at Valeant.

The stock’s slump affected its investors and the largest mutual fund holder, Sequoia Fund, ended up as a big loser. Since Sep 18, SEQUX has lost 25.3%. Recent events related to this perhaps highlight the risks of concentrated holdings or investing too much in one stock.

In late October, Vinod Ahooja and Sharon Osberg , two of the five independent directors of Sequoia Fund, resigned from the board. Separately, the fund house had to post a letter on its website to defend its significant investment in Valeant.

The letter stated, “We have been asked by clients and friends why we own such a company. In our view, Valeant is an aggressively managed business that may push boundaries, but operates within the law… We believe the company will learn from the current crisis the importance of reputation and transparency to all stakeholders, especially the shareholders.”

Focused Funds & Risks

Focused funds are ones that invest in a limited number of companies, rather than having a diversified portfolio. The advantage of a diversified portfolio is that losses from certain investment instruments can be offset by gains in others. So the risk is diversified. However, for the concentrated or focused funds, the fate solely rests on the direction that the limited numbers of stocks are taking – either north or southward.

A counter argument here is that well-chosen stock picks that are surging can also translate into significant gains for mutual funds. However, does that terminate the risk of the stock stumbling on hurdle and slipping into the bear territory?

A case in point is Putnam Equity Spectrum A (PYSAX), which has 20.3% exposure to Dish Network. While in 2014 Dish Network gained 26.4%, PYSAX registered gains of nearly 3%. However this year, DISH’s 11.7% year-to-date loss of 11.7% is in tune with the 10.5% loss slump in the Putnam Equity Spectrum A fund.

At the end of last year, Fairholme Fund (FAIRX) had almost half of its assets invested in American International Group, Inc. (AIG). However, Fairholme has diluted the holding to 19.59%, while 19.16% of its assets are invested in Bank of America (BAC) and 10.9% in Sears Holdings ( SHLD).

Funds with Above 10% Exposure to Single Stocks

Some market experts are of the opinion that the purpose of a mutual fund is questionable when it has over 10–15% exposure to a single stock. However, we do have some examples of funds having at least 10% exposure to a certain stock.

To begin with, Blue Chip Investor (BCIFX) has 30.8% of its assets invested in Berkshire Hathaway Inc. (BRK.A). While Berkshire Hathaway is down 9.6% so far this year, BCIFX has lost 3.4%. As of Jun 30, the total issues in the stock holdings for this Zacks Mutual Fund Rank #4 (Sell) fund was 14.

Fairholme Allocation (FAAFX) and Fidelity Select Computers Portfolio ( FDCPX) also have at least 20% invested in a single stock. FAAFX has invested 23.3% in Sears Holdings, while FDCPX has a 20.6% exposure to Apple Inc. (AAPL). FDCPX has also invested 9.2% in EMC Corporation (EMC).

Year to date, Fairholme Allocation has lost nearly 7% while SHLD is down 33.7% in the same period. FDCPX has slumped 10.1% year to date. While Apple is up 6.3%, EMC has slumped 15.4% year to date. FAAFX has just 9 issues in the stock holding, FDCPX has 30. Both FAAFX and FDCPX carry a Zacks Mutual Fund Rank #3 (Hold).

Separately, Fidelity Select Telecommunications Port (FSTCX) and Putnam Global Technology A (PGTAX) are two funds that have at least 10% invested in two separate stocks. Moreover, total issues in these stock holdings are also fairly high. FSTCX has invested 24.4% and 15.4% in AT&T, Inc. ( T) and Verizon Communications Inc. (VZ), respectively.

In case of FSTCX, year-to-date losses of respectively 0.2% and 3% for AT&T and Verizon were in contrast to the 2.5% gain for the fund. Perhaps, having 50 total issues in stock holdings helped to mitigate the loss. For example, among other holdings T-Mobile US, Inc. ( TMUS) and Telephone & Data Systems Inc. (TDS) have gained 38.5% and 14.1 and FSTCX has invested 4.5% and 2.7% in them, respectively. FSTCX carries a Zacks Mutual Fund Rank #1 (Strong Buy).

Coming to PGTAX, it has 11.9% invested in Alphabet (GOOGL) and 10.6% invested in Apple. Year to date, PGTAX has jumped nearly 12%, riding on Google and Apple’s year-to-date gains of 43.2% and 6.3%, respectively. PGTAX holds a Zacks Mutual Fund Rank #2 (Buy).

So, taking a call to either invest in or abstain from concentrated funds depends on investors’ investment objective as the element of risk stemming from the direction of the largest stock holding decides their fate. While investing in PGTAX and FSTCX has proved fortunate, SEQUX, BCIFX and FAAFX have not been too lucky.

For investors interested in concentrated funds, watch out for our next article in the Mutual Fund Commentary section where we will share with you the best funds to buy and the ones to sell with concentrated holdings.

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