The answer for some planners is to use concentrated portfolios for some equity positions. Exactly what constitutes a concentrated portfolio is open to question. Some people would consider a fund holding 50 or fewer stocks concentrated. Certainly, a stock fund with fewer than 30 issues would qualify. According to Morningstar, 350 equity portfolios in its database recently held fewer than 30 stocks.
How well these non-diversified funds do depends on the skill of the manager or managers. Morningstar analyst Kevin McDevitt sees concentrated funds as a powerful tool in the right hands. "In the wrong hands, they can be an absolute disaster," he says.
Roy M. Blumberg, director of client portfolio management at the Philadelphia Group, keeps a majority of the firm's clients' equity assets in index ETFs, citing lower costs and the reality that "most managers don't outperform the benchmarks over time." Even so, Blumberg does occasionally use a fund that holds a limited number of positions "if we truly believe that what the concentrated portfolio is focused on will help us reach our goals and objectives."
He cites the firm's recent use of a concentrated portfolio of master limited partnerships that met dividend and cash flow goals and contributed to total return. But Blumberg sees concentrated portfolios as tactical rather than strategic. He holds such positions as long as they remain attractive, but will not make any one of them a permanent part of the mix. "I describe myself as a long-term renter," he says.
Robert Wander, a planner at New York-based Wander Financial Services, agrees with Blumberg on indexing in at least one equity category. "In the U.S. large-cap equity space, for example, generally speaking I would be more oriented toward an index approach," he says.
But Wander prefers more concentrated portfolios in just about every other equity category. He notes that with active managers, you want their strongest conviction stocks. Once you get beyond about 30 stocks, he says, managers "start getting into second-tier names" to just round out the portfolio.
That's a point that Edward K. von der Linde, portfolio manager of the Linde Hansen Contrarian Value Fund (LHVAX), would endorse. His fund, started last February, generally holds 20 to 40 securities. He doesn't see concentration as an additional management burden.
"That's where the opportunity is," von der Linde says. "That's how you build wealth."
And von der Linde does most of his searching for good investment ideas in the mid-cap area. "Large-cap, in general, is really well owned," he notes. At the other end of the size spectrum, small-cap equities provide too many choices. "It makes it more difficult to separate the opportunities from the dead ends," he says.
BEWARE OF VOLATILITY
When managers limit their portfolios to a few stocks, the result can be more volatility. But, Morningstar's McDevitt argues, that doesn't have to be the case. He cites the Sequoia Fund (SEQUX) and the Yacktman Fund (YACKX) as examples. "There are a lot of concentrated funds that tend to be more long-term oriented," he says. "They'll buy at value prices, but then they'll hold on for the long term."
But highly concentrated funds can and do stumble. How much leeway should advisors give these managers? When does it make sense to exit the position?
"I tend not to be trigger happy," says Wander, who tries to understand what's behind a fund's results. "Is there a reasonable explanation for why there is underperformance?"
For Blumberg, it comes down to a question of process. If the manager changes style, "that's always a concern to me," he says.
Sometimes, planners simply ask themselves an old question: Can you sleep well at night owning this investment? Stan Johnson of Comprehensive Financial Planning in Durango, Colo., once held the concentrated Fairholme Fund (FAIRX) in client portfolios. "I actually sold out of that ... because I saw the big bet in financials and wasn't comfortable with that," he says. Johnson admits that he has no formula to cite. "It's more an art than a science," he explains.
PROTECTING THE DOWNSIDE
A formula is very important to Rich Winer of Winer Wealth Management in Woodland Hills, Calif. He uses a concentrated portfolio for equities, picking the stocks himself using fundamental analysis. He then relies on a technical analysis program to tell him when to sell a position. "Protecting the downside is always job one," he says.