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Fund Spy

Rising Concentration Points to New Risks

These funds have become more concentrated among top holdings during the past three years.

 Valeant Pharmaceuticals(VRX) recent plunge--and the pain endured by its largest shareholders--highlights the risks of taking large bets on individual companies. Several fund managers held sizable stakes in the stock, though  Sequoia (SEQUX) stood out for its position, which reached 29% of fund assets in mid-2015. The fund lost 22% from August 2015 to November 2015 as Valeant’s stock price fell 65% on allegations of fraud and aggressive pricing practices.

That’s not to say investors should avoid concentrated funds. Patient investors with long horizons may find much to like with them. In fact, Morningstar’s analysts assign Sequoia a Morningstar Analyst Rating of Gold, reflecting their view that it is a best-of-breed fund for investors willing to ride out short-term bumps. Still, it is worth noting when a fund’s concentration markedly changes. Hopefully investors realized that Sequoia’s stake in Valeant had more than tripled as a percentage of the portfolio during the past three years. Keeping an eye on such changes helps keep investors apprised of the risks they face.

To identify situations where concentration risk has grown, we screened the Morningstar 500 for funds that have meaningfully increased their allocation to their top 10 holdings during the past three years. While the funds below don’t carry as much stock-specific risk as Sequoia, the recent changes still merit consideration.

 Royce Special Equity Multi-Cap (RSMCX) and  Royce Special Equity (RYSEX) have become considerably more concentrated in the past three years. The top 10 stock holdings grew to 58% of assets from 34% in the former, and to 48% of assets from 33% in the latter. Each fund currently keeps more than 7% of assets in its largest holding, compared with less than 4% three years ago. As the market rally gets long in the tooth, manager Charlie Dreifus says he’s found more names to sell than buy. He’s a stickler on valuations and faces the challenge many value managers do after a long rally. His strong record of managing risk is comforting. Still, the funds’ recent change in complexion bears monitoring. Several top names have turned in double-digit losses in the year to date through November 2015.

Westport (WPFRX) has also consolidated its portfolio. During the past three years, the fund’s number of positions has fallen to 32 from 50, while its top 10 names have grown to 54% of assets from 31%. It is nice to see that the top holdings have long held spots in the portfolio. Universal Health Sciences (UHS), the largest position at 8% of assets, was first bought in December 2008, and all of the other top 10 names were purchased in 2011 or earlier. Longtime skipper Ed Nicklin is in his late 60s, and the firm’s co-owner Andy Knuth is in his mid-70s, which raises concerns about succession planning, another reason to be cautious.

Delafield Fund (DEFIX) has about 40% of assets in its top 10 positions, marking a notable increase from 25% three years ago. It focuses on small- and mid-cap companies and holds no more than 5% of assets in any stock. While that may not seem to court significant company-specific risk, the fund stands out versus small- and mid-cap competitors, which tend to have more-diversified portfolios compared with large-cap strategies. The average small-cap fund holds 22% of assets in its top 10 holdings, while the typical mid-cap strategy stashes about 27% of assets in its 10 largest positions. Delafield is also concentrated from a sector standpoint, with 82% of the portfolio invested in just three sectors: materials, industrials, and information technology.

Leo Acheson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.