Focusing on Best Stock Picks Doesn't Mean Superior Returns

(MoneyWatch)  In his column on Tuesday, Wall Street Journal columnist Jonathan Burton stated: "The best stock funds often don't own many stocks." The question is: Do investors benefit from concentrating risks in a manager's best ideas?

An often-heard excuse for the failure of actively managed funds to outperform benchmarks is that the typical fund is "overdiversified" -- the manager's best ideas are diluted. In response, the mutual fund industry came up with a "solution" called focused funds: funds that concentrate holdings in the manager's best ideas. While most mutual funds hold well over 100 stocks, the typical focused fund will hold 40 or less.

If focused funds concentrate on a manager's best stock picks, then shouldn't they deliver superior results? A 2008 study, "Security Concentration and Active Fund Management: Do Focused Funds Offer Superior Performance?" examined more than 2,000 focused funds to see if they truly delivered additional returns. Here's what the study found:

• There was no evidence that focused funds outperform diversified funds. In fact, funds with more stocks significantly outperformed funds with fewer stocks once you account for other fund characteristics.
• The stocks that focused funds bought underperformed the stocks they sold by 0.3 percent at the one-year horizon.
• Focused funds have significantly higher volatility and tracking error compared to benchmarks.
• Focused funds go out of business at a higher rate than diversified funds.

There are a few explanations for the underperformance of focused funds. For one, trading costs grow as a fund takes a larger ownership stake. When these costs are coupled with relatively high operating expense ratios, outperformance becomes difficult. For another, the market is efficient enough that after expenses it becomes difficult to exploit any pricing errors.