If mutual fund flows are any indication, active management is facing serious headwinds. Between 2007 and 2014, equity index mutual funds and ETFs received $1 trillion in net new cash, according to the Investment Company Institute, while actively managed stock funds experienced net outflows of $659 billion.
Brian Macauley, who co-manages the Hennessy Focus Fund with David Rainey and Ira Rothberg, believes that with the right management, mutual funds can generate long-term returns in excess of their passive benchmarks. At the same time, he sees the trend toward indexing as a response to the shortfalls of traditional actively managed funds. “Most of them hug a benchmark, over-diversify and underperform over the long term,” he says.
None of those descriptions even remotely applies to Hennessy Focus. As a concentrated “best picks” offering, it usually holds between 20 and 30 stocks, with approximately 60% to 80% of assets in the top 10 holdings. By comparison, the average fund in Morningstar’s mid-cap growth category holds 70 to 85 stocks and has 20% to 25% of assets in the top 10.
Hennessy’s high-conviction ideas also tend to stay in the portfolio for at least five years, and often longer. And both its sector weightings and stock picks deviate significantly from its mid-cap benchmark, the Russell 3000 Index.
Being benchmark-agnostic often means deviating from market performance. Generally, the fund’s performance relative to the benchmark has been better during times of economic and market distress because of the fund’s focus on higher-quality companies, but the performance has been slightly worse when an expanding economy provides a tailwind for a broad swath of companies, regardless of quality. Over the last five years, the portfolio has captured 93% of the market’s upside return, while experiencing only 71% of the downside loss.
While the fund has underperformed over short periods, its longer-term returns shine. From its inception in 1997 through September 30, 2015, it produced an average annual total return of 13.4%, outperforming both the Russell 3000 Index and the Russell Midcap Growth Index by over 500 basis points, annualized. Macauley stops short of predicting whether the fund will beat the indexes in 2016, but does make the modest observation that in an environment of low inflation and slow economic growth, his portfolio companies “should do pretty well.” As for the market as a whole, he believes stocks are neither overvalued nor undervalued at current levels.
He attributes much of the fund’s long-term track record to its managers’ complete familiarity with every stock in the portfolio. “It’s hard to run a fund with 100 or 150 stocks and have insight into every one of them,” he says. “Mutual funds that outperform tend to have concentrated portfolios.”
According to a white paper from the firm, titled “Unconventional Wisdom,” several studies have shown that so-called “best ideas” mutual funds focusing on a maximum of 25 stocks tend to perform better than their more diversified counterparts over the long term, yet do not have higher risk profiles. But the paper also warned that “since ‘best ideas’ tend to be smaller and less liquid, concentrated portfolios may be less nimble. Therefore, investors should plan to hold focused funds for longer periods of time.”