Passive index investing is booming. More and more fund investors are turning away from actively managed mutual funds due to disappointing performance. However, anyone who opts for a passive equity fund or index ETF has given up the chance of excess returns from the outset. Focus funds are the better alternative. Find out why in this article.
Focus funds generate excess returns
Focused equity funds, which are characterized by a concentrated portfolio, are a small but select class of active mutual funds that stand out from the vast majority of conventional equity funds – in particular because they have a significantly higher probability of achieving excess returns over the long term.
The advantage of focus investing is based on the phenomenon, proven in empirical studies, that the top positions in conventional active mutual funds – i.e., the highest-weighted investments – not only outperform the benchmark index on average, but also outperform the fund itself.
Fund managers express their confidence through weighting. Put simply, the higher the weighting of a stock position in the fund, the more confident the fund manager is that this investment will outperform the market.
80-90% of conventionally diversified active equity funds underperform in the long term
So why do 80-90% of conventional active equity funds underperform their benchmarks? One key reason is that fund managers are often only able to identify a few truly attractive investment ideas because the market is usually – but not always – efficient. If fund managers are forced to hold more positions than they have attractive investment ideas due to UCITS diversification rules or their employer's product specifications, then this phenomenon is easy to understand.
In addition to diversification requirements, fund managers themselves often structure their funds more diversely than necessary, thereby significantly reducing the likelihood of excess returns. They add additional stocks to the top positions with low confidence simply to minimize the risk of deviation from the benchmark index.
In doing so, fund managers reduce their personal risk, but do not act in the best interests of their investors, who expect active equity funds to generate long-term excess returns. From their perspective, fund managers are acting rationally by avoiding personal career risks through so-called benchmark hugging, which is exacerbated by the widespread practice of measuring fund performance over the short term.
Focus funds as a solution to the dilemma of active equity funds
The solution to this dilemma? Quite simply, fund managers should only invest in their best investment ideas. The result is a focused fund with a concentrated portfolio containing significantly fewer securities than conventional equity funds. These are the fund managers' so-called high-conviction ideas, which they believe will generate above-average returns based on the insights they have gained.
Not surprisingly, empirical evidence shows that focused equity funds generate excess returns, as is the case with the top positions of conventionally diversified equity funds. Focused investing is the rational consequence of a selection logic that searches for the few truly attractive investment ideas in a market that is usually, but not always, efficient. Since these are so rare, these investment ideas should be weighted heavily and make up the majority of the portfolio. Concentrating on the fund manager's best investment ideas improves the risk-return profile of the focused fund compared to a conventionally diversified equity fund and its benchmark.
What does this mean for fund investors and their advisors?
Empirical evidence shows that successful focus investing generates excess returns for fund investors. The flip side of the coin is that the underperformance is also significant if the fund manager is unable to identify mispricings and profit from them. A fund manager or fund advisor who has a high probability of success in achieving above-average fund performance can be identified by their long-term track record, their investment logic, and ultimately also by the portfolio structure of their fund.
High active share of focus funds
An important indicator in this context is the so-called active share. It shows the portion of the portfolio that deviates from the benchmark index. An active long-only equity fund that does not hold any securities from the benchmark in its portfolio has an active share of 100%. A passive equity ETF that precisely tracks its benchmark index has an active share of 0%. A fund manager must deviate from its benchmark if it wants to achieve excess returns. Focus funds often have an active share of 90% or more. In contrast, the active share of conventional equity funds is significantly lower, often at 60% or less.
Number of titles and the question of diversification
Focus funds are, by their very nature, invested in only a small number of stocks. This repeatedly raises the question of whether they are sufficiently diversified. For the fund manager of a focused equity fund, the question of volatility is not only irrelevant. Focus investors reject this definition of risk outright. They see price fluctuations not as a risk, but as an opportunity and even a prerequisite for acquiring companies below their true value and achieving excess returns.
In fact, Buffett, Munger, and Keynes – arguably the best-known and most successful advocates of focus investing – see the real risk of buying shares, i.e., investing in a company, primarily in the probability of a permanent loss of capital. To avoid this risk of capital loss, a so-called margin of safety is required, i.e., the largest possible discrepancy between the stock market price and the intrinsic value of the company per share. On the one hand, this is intended to minimize the risk of permanent capital loss. On the other hand, this value-price discrepancy is the driving force behind the expected excess return. Advocates of focus investing see volatility not as a risk, but as an opportunity to acquire companies below their true value.
Fund investors in a focused active equity fund who nevertheless do not want to forego sufficient diversification – i.e., the volatility of the fund should not be significantly higher than that of the market or benchmark index – should note that only a surprisingly small number of securities are needed to achieve sufficient diversification. In a study conducted in 1968, Evans and Archer found that only 8-10 stock positions are sufficient to achieve satisfactory diversification in terms of volatility relative to the benchmark.
What should fund investors do?
It is more advantageous for fund investors to invest in active equity funds with concentrated portfolios rather than in traditional equity funds. Focus funds have a higher chance of generating excess returns and can offer sufficient diversification even with a very small number of equity positions.
In reality, many fund investors have several conventional mutual funds in their portfolios. This means that fund investors are invested in many, sometimes hundreds, of individual securities, and the portfolio as a whole is massively over-diversified – at a high price. Why? The portfolio more or less mirrors the overall market, thereby reducing the chance of excess returns to virtually zero. What remains are the high fund costs of active mutual funds and the empirical fact that fund returns are further reduced by all kinds of negative effects resulting from behavioral anomalies on the part of fund management. A lower return on the portfolio compared to the overall market is almost guaranteed.
This over-diversification at portfolio level and the resulting lower returns are often accompanied by a high level of switching activity between individual funds. This is to the detriment of fund investors, whose lower returns are further reduced by procyclical investor behavior and transaction fees.
A better, i.e. rational, strategy for fund investors is to invest either in concentrated, active funds or directly in low-cost passive index ETFs. The first strategy promises a real chance of excess returns with the risk of a negative deviation from the market return. The second—passive – strategy guarantees market returns but at the same time eliminates the chance of excess returns. However, this only applies to broadly diversified global passive equity index ETFs. With thematic, sector, or so-called active equity ETFs, deviations from overall market performance can be enormous, either positive or negative.
Focus funds in Germany
In my opinion, a focused fund invests in fewer than 15 securities, with the five largest individual investments together accounting for more than 50% of the fund's weighting. This level of concentration and focus cannot be replicated by a UCITS fund, as these are subject to the so-called 40/10/5 rule, which stipulates over-diversification. An AIF is exempt from this restriction and can invest in the best investment ideas in a focused manner. However, there are very few of these that are approved for distribution to all investors in Germany.
In Germany, public equity AIFs, which allocate fund investors' money in a focused manner to carefully selected company investments according to the principle of focus investing, unfortunately occupy a niche position. In other countries with more advanced capital markets, particularly the US and the UK, there is a much wider selection and focused investing is well established. Empirical evidence shows that this is for good reason. For example, endowment funds at major US universities invest specifically in focus funds in order to benefit from the potential for excess returns offered by these vehicles and the expertise of the fund managers and fund advisors behind them.
Performance of a famous focus investor
It is interesting to note that Warren Buffett's Berkshire Hathaway has weighted the five largest stocks in its equity portfolio at more than 70% – even after Buffett halved his largest position in the first half of 2024 (Apple). Warren Buffett is arguably the most famous representative of the focus investor class and does not do things by halves. For shareholders, this high portfolio concentration has more than paid off for almost 60 years. Without Berkshire Hathaway's concentration of capital on the best investment ideas of Warren Buffett and Charlie Munger, Berkshire Hathaway's cumulative return of 4,400,000 percent since 1965 (yes, that's right: million percent) or approximately 20% per annum would certainly not have been possible. By comparison, the diversified S&P 500, including dividends, achieved only 31,000 percent or around 10% per annum over the same period.
The MAXVAL Fund
As a fund manager, I realized early on that my top 10 investment ideas outperformed the overall fund, the benchmark index, and the vast majority of competing funds over the long term. Since then, I have been a staunch believer in focused investing. After 20 years of experience as a portfolio manager, I launched the focused global equity fund, MAXVAL Investment Partners (LU2421085155), at the end of 2022.
The capital of the MAXVAL fund, for which I am the fund advisor, is allocated to the 8-12 best investment ideas that I filter out of a global equity universe using in-house research and analysis with a selection logic that has been proven over 20 years. The active share of the MAXVAL fund is over 97% relative to the MSCI World and currently holds 12 company investments. The MAXVAL Fund is well diversified across sectors, regions, size classes, and business models of the company holdings and has the potential to generate excess returns for its fund investors over the long term.
Want to find out more?
You can receive the empirical studies on the topic of “Focus Fund” as a PDF file and further information on the MAXVAL fund, such as the fund profile and the latest partner letter, by sending an email with the keyword “Focus Fund” to This email address is being protected from spambots. You need JavaScript enabled to view it.. If you are interested in learning more about this topic and the fund, I would be happy to discuss it with you personally.
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Investment advice according to section 2 para. 2 no. 4 German Wertpapierinstitutsgesetz (WpIG) and investment brokerage according to section 2 para. 2 no. 3 German Banking Act shall be made on behalf of, in the name of, for the account and under the liability of the responsible legal entity BN & Partners Capital AG, Steinstraße 33, 50374 Erftstadt, according to section 3 para. 2 WpIG. BN & Partners Capital AG has a corresponding license from the German Federal Financial Supervisory Authority (BaFin) in accordance with section 15 WpIG for the prenamed investment services.