The Sad Tale of Concentrated Value Funds

They need index fund competitors

John Rekenthaler 30 May, 2016 | 9:23
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Small Is Beautiful?
Patrick O'Shaughnessy's article, "Alpha or Assets," advocates "targeted" indexing. As O'Shaughnessy points out, most index fund providers build their lineups to accommodate scale, by creating funds that hold large numbers of securities. Such a decision makes perfect sense for traditional index investing, which seeks to replicate the showing of entire markets.

The approach may, however, be a drawback with the new wave of strategic-beta (or "smart-beta") indexing. Those funds carry implicit performance promises. In some fashion, their promoters suggest, they will outdo traditional index funds. In short, strategic-beta funds are the indexed version of active investing, living on the suggestion of outperformance, and dying if that suggestion goes unfulfilled. As such, they might be better served by trimming their portfolios to own only the most-attractive issues. They might wish to target.

That all makes sense, but it's important to note that we've been here before. Twenty years back, similar arguments were made for concentrated stock funds, which, as targeted index funds would later do, proclaimed the virtues of holding stripped-down portfolios. The story offered by concentrated-fund managers was compelling: Rather than force portfolio managers to spread their insight among hundreds of stocks, let them invest solely in their favored few. Many nodded in agreement, and purchased such funds.

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John Rekenthaler  is vice president of research for Morningstar.

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