Funds that make concentrated bets on a few stocks are paying the price in this rough market
By now almost everyone knows that ARK Innovation ETF (ARKK) is having a very bad year. But poor stock selection is not the only reason why the fund, run by celebrated stock-fund manager Cathie Wood, is doing so poorly. Another, overlooked, culprit: the portfolio is heavily concentrated in just a few stocks.
According to Morningstar Direct, ARK Innovation's 10 largest holdings represent 58.9% of the portfolio. That's more concentrated than 93% of all other actively managed U.S. equity funds (both open-end and ETF) in Morningstar's database. It's more than double the concentration of the S&P 500 index, where the 10-biggest stocks represent 27.7% of the total market cap of the index.
This year through June 2, according to FactSet, ARK Innovation is down 51.8%, more than four times the comparable total return loss of 11.9% for the S&P 500.
To find out if ARK Innovation is more the exception than the rule, I analyzed the year-to-date returns of the 10% of actively-managed U.S. equity funds in Morningstar's database with the most concentrated portfolios. These are the funds with the highest percentages allocated to their 10 largest holdings. On average, this decile of funds lost 13.3% through June 2, according to Factset, 1.4 percentage points worse than the S&P 500.
Nor is 2022 a fluke. Over the past 10 years, this most-concentrated decile lagged the S&P 500 by 2.0 annualized percentage points -- 14.7% annualized to 12.7%.
To be fair, lagging the market is not just confined to the decile of funds with the most concentrated portfolios. Nevertheless, these averages show that making big and bold bets by no means guarantees success.
Concentration can pay off
This otherwise dismal picture of concentrated funds isn't the end of the story. It turns out that a greater proportion of such funds beat the market over the long term than less-concentrated funds. Over the past decade, for example, 27.6% of the funds in the most concentrated decile beat the S&P 500's total return, versus 12% among funds outside this most concentrated decile.
What this means: If you were picking a fund at random from the decile of most concentrated funds, you'd have about a one-in-four chance of beating the market. In contrast, you'd have a one-in-eight chance of beating the market when picking a fund at random from funds not in this most-concentrated decile.
That's the good news. The bad news is that funds in the most-concentrated decile also have a greater chance of significantly lagging the market.
To quantify this good news/bad news story, consider the range of 10-year returns for the least- and most-concentrated portfolios. For funds in the most concentrated decile, that range extends from plus 22.6% annualized to minus 19.9% -- a spread of 42.5 percentage points. For funds in the least concentrated decile, that range extends from plus 13.7% annualized to plus 6.8% -- a spread of 6.9 percentage points.
The investment implication: You can play it safe or go for broke. When you play it safe, you forfeit the possibility of beating the market by very much or at all, in order to reduce the risk of lagging the market by large amounts. It's just the opposite when you go for broke: You incur the risk of big losses in order to have a chance at big gains. The choice is yours.