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Mutual Funds Offer Ready-Made Diversification
The Turnaround Letter always stresses the importance of diversification as the best, and—in some cases only—way to reduce risk to your investment portfolio. Even the most thoroughly-researched investment idea may not work out as you had hoped. There are just too many things that can negatively affect a company, and many of them cannot be predicted. If you diversify effectively, an unlucky pick or two should be more than offset by the gains from other holdings.
For many investors the best way to obtain diversification is through mutual funds, which offer an easy way to get a broadly-diversified portfolio. Given The Turnaround Letter’s contrarian investing bent, we don’t like just any mutual funds though; rather, we prefer those funds that either focus on turnaround investing as part of their strategy or are themselves something of a turnaround.
Unfortunately, there are very few mutual funds that really focus on turnaround investing. In fact, out of the thousands of mutual funds out there, we could only find a dozen, all of which are detailed in our contrarian investing newsletter. Even in these identified funds, turnaround investing is usually not their principal objective: In most cases, it is just one of several strategies that the fund manager pursues. In some ways the scarcity of turnaround-oriented funds just validates The Turnaround Letter's assertion that turnarounds represent an inefficient--and therefore potentially very profitable--niche in the securities markets. Even professional investors tend to shy away from turnarounds because they require a somewhat different analytical approach from more mainstream stocks.
Another reason why there are very few turnaround mutual funds today is that there is no index of turnarounds. Today, most mutual funds (and the people who sell the funds) want to compare their returns to a certain benchmark, usually a well-known index like the S&P 500. As a result, most fund managers tend to hug their benchmarks fairly closely. These fund managers are risk averse. They want to keep their jobs, after all; and they give up the opportunity to outperform their benchmark in exchange for reducing the risk of underperforming. Since turnaround stocks are underrepresented in the major benchmarks, fund managers are hesitant to buy them. With all that said, however, the managers of the funds we've identified are brave enough to put at least a portion of their portfolios in turnaround situations, and many of them have posted strong returns over the years because of that.