Theme and Background
This chapter examines the severe challenges faced by actively managed funds in 2014 and recent years, and why Oakmark believes its active, concentrated investment strategy can still achieve sustained success. The report notes that in 2014, only 10% of stock funds outperformed the S&P 500, with an average return of 8% versus the S&P 500's 14%. Over the past three years, they lagged by an average of 7 percentage points, and the gap widened to 9 percentage points over five years, prompting a significant shift by investors toward index funds.
Core Thesis
The author's central investment argument is that the success of actively managed funds should not be defined by annual rankings, but rather by long-term cumulative returns and risk-adjusted performance. Counterintuitive judgments include:
- As a whole, actively managed funds must underperform the market (after fees), but individual funds can consistently generate excess returns by exploiting the emotions and impatience of other investors.
- Concentrated holdings (rather than broad diversification) are key for actively managed funds to achieve excess returns, because broad diversification equates to "pseudo-indexing," making it nearly impossible to outperform the market after fees.
Key Arguments and Data
- 2014 Performance Data: Only 10% of stock funds outperformed the S&P 500; average return was 8% versus the S&P 500's 14%.
- Long-Term Performance Gap: Lagged by an average of 7 percentage points over the past three years, with the gap widening to 9 percentage points over five years.
- Definition of Success: The author cites a New York Times study showing that none of the 2,862 funds managed to stay in the top quartile of returns every year after the market bottom in March 2009, but argues this is not a reasonable standard for success.
- Risk and Return Relationship: The author challenges the academic view that risk and return are perfectly correlated, arguing that actively managed funds can achieve excess returns without increasing risk, by capitalizing on the emotional behavior of other investors.
- Logic of Concentrated Holdings: The average stock fund holds 121 stocks, but the author argues that broad diversification dilutes the impact of successful picks, making it nearly impossible for a fund to outperform the market after fees.
| Metric |
Active Fund Average |
S&P 500 |
Gap |
| 2014 Return |
8% |
14% |
-6 percentage points |
| Past 3-Year Return |
Lagged by 7 percentage points |
Benchmark |
-7 percentage points |
| Past 5-Year Return |
Lagged by 9 percentage points |
Benchmark |
-9 percentage points |
| Average Number of Holdings |
121 |
- |
- |
Companies/Assets Involved
- Oakmark Fund: The subject of the report, which did not rank among the 10% of funds that outperformed the market in 2014. The author acknowledges that its underperformance was primarily due to heavy exposure to financial stocks (especially banks) and an underweight position in healthcare stocks, but emphasizes this is typical of its long-term value investment strategy—selling strong sectors and adding to weak ones.
- Apple (AAPL) and Microsoft (MSFT): As representatives of large-cap companies, their strong performance contributed significantly to the S&P 500, but many mutual funds did not fully benefit due to having lower weightings in these stocks than the index.
- Nestle, Diageo, Unilever: As representatives of non-U.S. global companies, their performance in 2014 lagged far behind their U.S. peers in the S&P 500, dragging down the returns of funds holding these stocks.
Investment Implications
- For Investors in Actively Managed Funds: Do not judge fund managers by short-term annual rankings; instead, focus on long-term cumulative returns and risk-adjusted performance. Choose managers with clear, repeatable investment processes (such as value investing and concentrated holdings) who can exploit market sentiment swings.
- For Index Fund Investors: The report does not oppose passive strategies but notes that actively managed funds as a whole are bound to underperform the market, making index funds a reasonable choice for most investors.
- For Oakmark Investors: The author believes its historical success can be sustained because its investment approach—buying high-quality companies at prices below intrinsic value and waiting patiently—exploits the emotional and impatient nature of other investors, which is a constant of human behavior. The current underperformance is a normal phase of the strategy and should not be a reason to abandon it.
Theme and Background
This chapter discusses the issue of "over-diversification" in actively managed funds. Oakmark argues that many investors and funds themselves dilute their best investment opportunities through excessive diversification, causing portfolio performance to converge with the market while still paying high active management fees. The author emphasizes that concentrated holdings in the best stock picks are key to achieving excess returns.
Core Views
- Concentrated Holdings Outperform Over-Diversification: Oakmark believes that the benefits of reducing risk by increasing the number of holdings are far outweighed by the returns lost from diluting the best stock picks. Its fund holds only 20 to 60 stocks, and even its most diversified portfolio has only half the average position size of competitors.
- Investors' Own Over-Diversification Is a Hidden Trap: Many investors hold dozens of funds, each highly diversified, resulting in an overall portfolio that is essentially identical to a market index. Yet they pay full active management fees, making the probability of outperforming the market negligible.
- Active Management Still Has Value: For disciplined, non-panicking investors, active management offers as many opportunities as ever. Human nature remains unchanged, and market inefficiencies persist.
Key Arguments and Data
- Oakmark's Concentration Level: The top five holdings of the Oakmark Fund (Nestle 1.5%, Diageo 1.4%, Unilever 1.3%, Apple 2.0%, Microsoft 1.5%) total only 7.7%, but the overall portfolio consists of just 20-60 stocks, far fewer than peers. The Oakmark Select Fund holds none of these stocks (all at 0%), reflecting an even more extreme concentration strategy.
- The Math of Over-Diversification: When an investor holds dozens of funds, each highly diversified, the overall portfolio's return approaches that of the market index. After deducting active management fees, the probability of outperforming the market is "de minimis" (negligible).
- Comparison with Index Funds: The author respects index funds and agrees with John Bogle's view that many investors lack the ability to identify excellent funds and the patience to hold them, making index funds a better choice. However, for disciplined investors, active management still offers opportunities for excess returns.
Companies/Assets Involved
- Oakmark Fund: Concentrated holdings, with top five positions in Nestle, Diageo, Unilever, Apple, and Microsoft, totaling 7.7%. Its strategy is to "restore shareholders' opportunity for excess returns."
- Oakmark Select Fund: A non-diversified fund with even more concentrated holdings, holding none of the above stocks. It has higher volatility but greater potential returns.
- Index Funds: Viewed by the author as competitors, but not disparaged. The author believes index funds are a better choice for most investors.
Investment Insights
- Avoid Over-Diversification: Investors should review their portfolios. If holding too many funds results in a portfolio that mirrors the index, they should consider reducing the number of funds or switching to concentrated active funds.
- Choose Concentrated Active Funds: Oakmark's strategy shows that concentrated holdings in the best stock picks (e.g., 20-60 stocks) are an effective path to excess returns, though higher volatility must be accepted.
- Discipline and Patience Are Key: The success of active management depends on investor discipline—not panicking or redeeming during difficult times. Otherwise, even correct stock picks cannot realize returns.