Concentrated Funds Beating the Benchmarks

NEW YORK ( Thestreet) -- When Internet stocks crashed in 2000, many actively managed mutual funds went off the rails. Technology-heavy portfolios suffered big losses, lagging the S&P 500 by wide margins.

To avoid trailing so badly again, some managers stopped overweighting particular stocks or industries. Instead, funds began keeping their industry weightings close to the figures of the benchmarks. If the S&P 500 had 17% of its assets in technology, then the managers would hold a similar weighting. The aim was to keep returns roughly in line with the index -- and avoid antagonizing shareholders.

To appreciate how cautious funds have become, consider a measure known as R-Squared that ranks funds on a scale of 0 to 100. Index funds that move in lockstep with the benchmark have an R-Squared of 100. With many managers playing it safe, the average large blend fund has an R-Squared of 96, according to Morningstar. Funds that score higher than the average could be closet indexers -- which charge high fees for active management but deliver index-like returns.

To beat the benchmark, look for managers that differentiate themselves. Among the most distinctive choices are focused funds that typically hold less than 40 stocks. Focused portfolio managers place sizable bets on a few names, hoping to score big gains.

Top-performing focused funds include Virtus Small-Cap Core ( PKSAX) and Invesco Endeavor ( ATDAX). Both funds topped their benchmarks by wide margins and recorded R-Squareds of less than 90.

While many focused funds can be volatile, Virtus is particularly notable because it has held risk in check. In the turmoil of 2008, Virtus topped its average peer by 7 percentage points. During the past 5 years, the fund returned 12.1% annually, outdoing peers by almost 2 percentage points.

The portfolio managers aim to limit risk by sticking with the highest quality companies. Holdings must have strong balance sheets and secure market niches.

"We want to find companies where there is little risk that profits will be disappointing," says Portfolio Manager Jon Christensen.

Such rock-solid companies rarely sell at big discounts. But Christensen seeks to avoid overpaying by waiting until some temporary problem depresses the shares a bit. Once he buys, the manager holds on for years. His aim is to ride along as companies deliver consistent earnings and increase market share. Virtus only turns over 15% of its portfolio annually, compared to a figure of 87% for the average peer.

A holding is Pool ( POOL), which distributes chemicals and supplies that are used to maintain pools. As the largest player in the field, Pool can buy in bulk and undercut competitors. While new construction of pools collapsed during the financial crisis, sales of supplies remained fairly steady. "If you own a pool, you need chlorine and conditioner every week," says Christensen.

The fund also owns Computer Programs and Systems ( CPSI), which supplies information technology for rural and community hospitals. Demand is climbing because the Obama administration is requiring health care providers to install electronic records.

Invesco Endeavor seeks solid companies selling at big discounts. Many holdings are in industries that have fallen out of favor. The managers search widely for bargains, taking both growth and value stocks. Most often the approach has succeeded. During the past five years, the fund returned 13.4% annually, outdoing 96% of its peers in the mid blend category.

A holding is Ultra Petroleum ( UPL), a producer of natural gas. Because of the success of new hydraulic fracturing techniques, the market has been flooded with supplies, and the price of gas has sunk. That has hurt the shares of gas producers. But Invesco portfolio manager Mark Uptigrove argues that Ultra Petroleum will thrive as demand grows for clean-burning gas.

The company is one of the lowest-cost producers because its reserves in Pennsylvania are in relatively shallow fields that are easy to tap. "There is a tremendous value in being a low-cost producer in a commodity business," says Uptigrove.

Another holding is Cognizant Technology Solutions ( CTSH), which provides information technology consulting and outsourcing. Revenue has been growing, but the stock has been held back because of concerns about immigration reform, says Uptigrove.

The company's employees include foreign experts who come to the U.S. with temporary visas. Some proposed laws would curtail visas, but Uptigrove argues that the company can adjust to any changes that Congress is likely to make.

A promising new fund is GoodHaven ( GOODX), which holds 23 stocks. Before establishing the fund in 2011, portfolio managers Larry Pitkowsky and Keith Trauner worked at Fairholme ( FAIRX), a concentrated fund that outdid 99% of its peers during the past decade.

Fairholme achieved its stellar record by placing outsized bets on a few unloved stocks. The GoodHaven managers are practicing a similar strategy. During the past year, GoodHaven returned 30.9%, topping the S&P 500 by 2 percentage points.

The fund's biggest holding is Hewlett Packard ( HPQ). The managers started buying the depressed stock in the summer of 2012. At the time, media reports suggested that declining personal computer sales would make it difficult for the troubled company to revive. But the managers figured that some of Hewlett-Packard's data storage and commercial printer businesses were still solid.

Since then, the stock has soared as prospects have brightened, but the shares still sell for a forward price-earnings ratio of 7. Keith Trauner says that the shares are still cheap.

"If the company can start to grow in the low single digits, we will make a lot of money," he says.

At the time of publication, Luxenberg had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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