Concentrated Mutual Funds, ETFs: Dumb Investment of the WeekVW Staff
Concentrated Mutual Funds and ETFs: Dumb Investment of the Week by Ben Strubel, Strubel Investment Management
This week’s Dumb Investment of the Week is inspired by Ken Heebner of CGM Focus Fund (MUTF:CGMFX)'s colossally bad bet on interest rates rising. Unfortunately, he isn’t the only fund manager to make concentrated bets that have been detrimental to investors. Other mutual fund managers, hedge fund managers, and even ETF managers (or funds following poorly constructed indexes) have done the same.
Since the article was inspired by CGM Focus, let’s start with that fund. Here is the fund’s description, with emphasis added to two important items:
The investment seeks long-term growth of capital. The fund typically invests in stocks of between 20-100 companies at one time. It is flexibly managed so that it can invest in equity securities in a variety of industries as well as in foreign companies. The fund may invest in companies of any size, but primarily invests in companies with market capitalizations of more than $5 billion. If market conditions so warrant, it may establish short positions in specific securities or stock indices. The fund may also invest in debt and fixed income securities, including junk bonds. It is non-diversified.
Let’s start with the good part. The fund does tell investors it’s non-diversified, so investors should be prepared for owning a fund with concentrated positions. The problem is the second sentence, highlighted at the beginning. Based on that description I, as a regular retail investor, am under the impression that I’m paying Ken Heebner to invest a concentrated basic of growth companies. Indeed, most of the fund’s description is related to investing in stocks. It would be quite surprising to find out Heebner established a position shorting treasuries that represents almost a third of the fund.
Heebner isn’t alone. Another star fund manager, Bruce Berkowitz, has plowed almost all the assets of the Fairholme Fund (MUTF:FAIRX) into financials. He has invested almost 90% of the fund in a combination of American International Group Inc (NYSE:AIG) (47%), Bank of America Corp (NYSE:BAC) (15%), and Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) preferred securities (16+%).
The problem isn’t just limited to actively managed mutual funds. Another area where extreme concentration rears its ugly head is in the ETF space where some ETFs devotedly follow poorly constructed indexes.
For example, let’s look at the Health Care SPDR (ETF) (NYSEARCA:XLV). It has 32% of the fund in only four holdings: Johnson & Johnson (NYSE:JNJ), Pfizer Inc. (NYSE:PFE), Merck & Co., Inc. (NYSE:MRK), and Gilead Sciences, Inc. (NASDAQ:GILD). JNJ makes up almost 12% of the fund.
What about Vanguard, which is known for low fees and investor advocacy? Not even they are exempt from dumb funds. The Vanguard Telecommunication Services ETF (NYSEARCA:VOX) is basically AT&T Inc. (NYSE:T) and Verizon Communications Inc. (NYSE:VZ) stock masquerading as an ETF. Each company makes up 23% of the fund.
Since I don’t want just to point out the bad, here are three alternatives to poorly constructed ETFs.
- Try the iShares Global Healthcare ETF (IXJ). The weightings are more reasonable plus the fund has exposure to more than just US-based healthcare companies (for most foreign pharmaceutical companies the US is their largest market anyway).
- The iShares U.S. Telecommunications ETF (IYZ) isn’t that great, because Verizon and AT&T still make up 32% of the ETF. But it’s better than the Vanguard offering.
- If you are determined to get exposure to the US telecom market, just straight up buying of AT&T and Verizon stock (note, we own both) is probably your most cost-effective choice.
I will give some credit to ETF providers, as some previously terrible funds have been improved. In a 2010 Forbes article that talked about this concentrated-fund issue, the author mentioned iShares MSCI Mexico Inv. Mt. Idx. (ETF) (NYSEARCA:EWW) where America Movil SAB de CV (ADR) (NYSE:AMX) (NASDAQ:AMOV) accounted for 27% of the fund. The fund has now capped the weightings, and America Movil is down to just over 17%. It’s still a concentrated fund but a huge improvement from 2010.
Why Would Anyone Buy Concentrated Mutual Funds?
Fairholme has total disclosed annual expenses of 1%, and CGM Focus has total disclosed annual expenses of 1.09% according to Morningstar. My question is this: What is the point of owning such concentrated funds? Especially when they are sold to investors in managed accounts via brokers or advisors. (I encountered both funds frequently during their respective heydays.) The performance of both funds will be almost completely determined by their huge bets: AIG for Fairholme and short Treasuries for CGM Focus. Investors are basically paying a 1% annual fee to buy AIG stock. If the funds are in a managed account, investors are now paying a broker about 1% for him (or her) to waste another 1% of their money on buying what amounts only to AIG stock.
Concentrated funds have their place, but when the concentration reaches a point of absurdity, I don’t believe investors are being well served. The volatility and risk in the fund goes up and the returns won’t be materially different from what investors (or advisors) would be able to do themselves by just buying the largest holdings in the fund.
Disclosure: Long VZ, T, JNJ, US Treasury bonds, bills, and notes