Why Concentrated Funds Put Your Money at Risk

In the category of “you’re right until you’re wrong,” chalk one up for the Sequoia Fund (symbol SEQUX). At one point this year, the fund, which has distant ties to Warren Buffett, was up by 18%, outpacing the broad market by 15 percentage points. But as of today, the fund is down 4.2% for the year and lags Standard & Poor’s 500-stock index by 7.4 points. Looking at it another way, from August 5, when Sequoia peaked, through October 29, the fund has plummeted 18.9%.

The explanation behind the rise and fall of Sequoia is a shockingly high concentration in a single stock: Valeant Pharmaceuticals (VRX). At last word, Sequoia had 29% of its $7.5 billion in assets invested in shares of the acquisitive Canadian drug company, which has been beset by Congressional scrutiny about its strategy of buying biotech and other health care companies and then aggressively raising prices of the acquired companies’ drugs, as well as allegations of fraudulent accounting. Since peaking at an all-time high of $283 in early August, Valeant shares have lost more than half of their value. The stock now trades at $111.50. (All prices and returns are as of October 29.)

Sequoia’s run-in with Valeant is a blemish on the record of an otherwise solid fund that happens to have an interesting pedigree: In 1970, when Buffett liquidated his investment partnership, he recommended that his shareholders invest with Sequoia, which launched in July of that year. (The story goes that William Ruane, who was running a money-management firm with Richard Cunniff, launched Sequoia in order to take in Buffett’s former investors. Ruane and Buffett had met while studying together with Ben Graham, the famous value investor, at Columbia University in 1951.)

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So what was Sequoia thinking, investing nearly one-third of its assets on a single stock? Actually, managers Robert Goldfarb and David Poppe were thinking that Valeant was going to keep growing like gangbusters. At a shareholder meeting last May, investors asked the managers several questions about Valeant and Sequoia’s hefty weighting in the stock. Goldfarb said the high share price reflected Valeant’s rapid growth, which he said the company expected to continue into 2016. He acknowledged that risks to the stock included changes in drug pricing by the government, among others. But he added that Valeant, through a series of smart acquisitions, had revamped its portfolio so that it was less vulnerable to the loss of patent protection on any individual drug, and that it was “now geared for substantial growth” driven by its stable of drugs. That’s significant only because the firm has grown mostly by acquisition heretofore.

Sequoia, which is closed to new investors, holds 41 stocks; the typical actively managed, large-company stock fund holds 116. All this led us to wonder about the danger of concentrated funds—those that hold relatively few stocks or have outsize positions in a single company. So we decided to take a closer look at funds with portfolios of 30 or fewer stocks.

Over long periods of time, the concentrated, or focused, funds we looked at delivered a mixed bag of performance. Some produced superior results; others have been awful. But most of the concentrated funds have been more volatile than Standard & Poor’s 500-stock index, based on measures of standard deviation over the past one, three, five, 10 and 15 years.

Raw returns don’t tell the whole story, however. Take CGM Focus (CGMFX), which holds just 20 stocks. Among the concentrated funds we looked at, it has an excellent long-term record, with a 13.0% annualized return over the past 15 years, compared with 4.8% annualized for the S&P 500. But Focus was also the most volatile over that stretch. Only two diversified U.S. stock funds have been more volatile over that time, Pin Oak Equity (POGSX) and Victory Munder Growth Opportunities A (MNNAX).

And it has indeed been a scary ride for CGM Focus shareholders: In 2007, Focus reached the pinnacle of the fund world, with an 80% return. But it swooned 48.2% in 2008. Since the end of 2007, the fund has an annualized loss of 3.2%, which trails the S&P 500 by an average of 10.1 percentage points per year.

Not all concentrated funds sink as much of their assets into one holding as Sequoia did with Valeant. But some come relatively close, and the results can be disastrous if the stock craters.

For example, Fairholme (FAIRX), with a portfolio of just 10 stocks, recently had 20% of its assets in American International Group (AIG). Shares of the financial-services giant, Fairholme’s largest holding, have held up well in recent months. But Sears Holdings (SHLD), which represents 11% of the fund’s $5 billion in assets, has been a drag. Sears has sunk 32.2% over the past year. Meanwhile, Fairholme’s one-year return of 3.3% trails the S&P 500 by 4.4 percentage points.

Matthew 25 (MXXVX), which holds 25 stocks in its portfolio, has 14% sitting in Apple (AAPL). The fund has 8% of assets invested in its number-two stock, Cabela’s, which dropped 18% over the past 12 months. Over that period, Matthew 25 lost 4.5%, while the S&P 500 gained 7.6%.

Not all focused funds send their shareholders on roller-coaster rides. Polen Growth (POLRX) holds 22 stocks, and its top 10 holdings account for 55% of its assets. Over the past three years, it has been no more volatile than the S&P 500, and yet it outpaced the bogey by an average of 2.7 percentage points per year.

And then there’s Akre Focus (AKREX), a member of the Kiplinger 25. The fund holds 27 stocks, and 63% of its assets sit in the top 10 holdings. Though it has been a tad more volatile than the S&P 500 since it opened in 2009, the fund has also been a consistent winner, beating the index in every calendar year, including so far in 2015, except one (2014). Its top holding, American Tower (AMT), accounts for 10.4% of assets. That stock gained 9.1% over the past year, slightly more than the S&P 500. Akre, buoyed by other holdings, such as insurer Markel (MKL), which was up 29.9% over the past 12 months, beat the index with a 9.1% return over the past year.