It's easy to get excited about a mutual fund with an amazing track record -- but a little digging into even the most admirable investment can raise questions worth considering.
Consider the remarkable record of the Fairholme Fund (FAIRX):
|3-Year Avg. Annual Return||6.7%||1.3%|
|5-Year Avg. Annual Return||8.2%||2.7%|
|10-Year Avg. Annual Return||11.5%||3.4%|
Source: Morningstar, as of April 1, 2011.
It's hard to argue with that kind of performance -- how could such a fund let you down? The manager, Bruce Berkowitz, has even been named Morningstar's stock fund manager of the decade. Over the past 10 years, the fund beat 99% of its peers.
The fund impressed me so much that I bought into it myself a year or two ago. Alas, I noticed recently that it seems to have stalled a bit. Over the past 12 months, it did gain 8% -- but the S&P 500 gained 15%. So far this year, Fairholme has sunk about 2%, while the S&P 500 has advanced 6%. In fairness, that alone is no reason to freak out, since you shouldn't judge a stock or stock fund's performance over a short period.
Still, a closer revealed a few telling details about how the fund does business. The fund holds 18% of its assets in cash, meaning that a healthy chunk of whatever you invest could just sit around uninvested, losing money to inflation. Considering the 1% expense ratio you'll pay Fairholme for the privilege of investing with the fund, you might prefer to see its managers putting more of that cash to work.
Again, in fairness, the cash issue isn't a dealbreaker for me. Big cash positions give managers the ability to meaningfully pounce whenever a good opportunity presents itself. If Fairholme's holding such a big chunk of its holdings in cash right now, Berkowitz and his team may not see many tempting bargains in the market at present.
A weighty consideration
The type of stocks the fund holds may also affect its returns. Among Fairholme's roughly two dozen holdings, exactly 0% represented communication services, energy, utilities, consumer defensive companies, or technology. In contrast, a whopping 68% of its assets rested with financial services companies. Nearly 10% went to American International Group (NYSE: AIG ) , with about 5% each in Citigroup (NYSE: C ) , Goldman Sachs (NYSE: GS ) , and Morgan Stanley, and another 3% in Berkshire Hathaway (NYSE: BRK-B ) .
Take a moment to decide whether you'd be comfortable with such a highly concentrated investment. If financial companies take a big hit, as most of them did in the recent credit crisis, Fairholme will suffer as wall.
Once again, this apparent weakness isn't necessarily a dealbreaker, provided you can stomach that risk. Many financial companies today appear undervalued, with further room to recover from their crash. Compared to a forward P/E ratio of roughly 14 for the S&P 500, Citigroup, Goldman, and Morgan Stanley recently had forward P/Es between 8 and 9. As for Berkshire Hathaway, savvy investors know that beyond the company's primary insurance business, it owns and invests in a wide variety of steady stocks.
Do your homework
When presented with potential red flags like these, it's smart to learn more about the fund managers' thinking. At Fool.com, we wrote in 2008 about Berkowitz's affinity for buying "inevitable winners." At that time, Canadian Natural Resources (NYSE: CNQ ) represented a big chunk of Fairholme's holdings; Berkowitz liked its large oil reserves and potential for future growth. His faith paid off in 2009, when the company gained 81%.
Not all his concentrated positions will win out, though. Berkowitz's big position in flooring specialist Mohawk Industries (NYSE: MHK ) reflected optimism about the housing industry, but it's still struggling after grim performance in 2009.
Considering Berkowitz's big investment in financials, he's clearly got a lot of confidence that a recovering economy will propel them upward. And in a recent interview, he waxed bullish on Sears Holdings (Nasdaq: SHLD ) : "I'm quite confident that Sears has the wherewithal to wait and prepare for an upturn in housing, which their business is very heavily tied to." Berkowitz has placed 5% of his shareholders' money in Sears.
No stock fund is a sure thing. Dig deep enough into any of them, and you'll find enough contrary indicators to give you pause. You must decide for yourself whether those imperfections are dealbreakers, or whether your faith in the fund's management is strong enough to let you hang on. Most actively managed stock funds underperform the S&P 500, but standouts do exist, if you can find them. If you don't have the energy for that, no less an investor than Warren Buffett recommends simple, low-cost index funds.
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