The further you are from owning individual companies . . .

The further you are from owning individual companies, the more your investment management tends to be rooted in the performance of markets (or sectors of the market) rather than rooted in the performance of businesses.

In a mutual fund, as we explain on our web site in this recent commentary, you don't actually own the stocks of businesses. The mutual fund owns -- in a giant pool -- those stocks in the businesses, and you own shares in the pool.

One important thing to realize about these pools is that, as they grow very large, they are forced to buy more and more companies in order to find a home for all the dollars in the pool. Look at the list of the top twenty mutual funds by holding, as listed in Wikipedia (but available elsewhere as well).

If you are a money manager with a pool of $94 billion under management, you cannot own just forty or fifty companies. You could not even own just ninety-four companies. You are forced, by sheer size to own hundreds of companies -- not because you particularly want to own hundreds of companies for investment reasons, but because you must find a place to spread all those assets. The top fund on the list above, for example, owned 286 companies in its portfolio when it last disclosed its holdings at the end of the third quarter of 2007.

In fact, you will be forced not only to own a large number of companies, but you will be forced to find relatively large companies (companies with a large market cap) to own. You won't be owning many companies with market caps under a billion dollars, because you will almost buy those companies outright if you put even a small percentage (less than one percent of your assets) into the shares of those companies.

This means that as these pools get larger, these companies own more and more of the same names in the S&P 500 (some may own more than half of the "entire market" if the S&P 500 is taken as a proxy for "the market"). It also means that they own many of the same companies as one another! There are only about 290 companies in the U.S. with market caps of $10 billion dollars or more (these numbers fluctuate slightly every day as stock prices rise and fall). There are only about 23 companies in the U.S. with market caps of $100 billion or more.

As mutual funds own more of the same companies as one another, and as the overall market, they cannot differentiate themselves by owning different businesses. It is hard for them to be able to say, "You invest in Apple, and I will invest in Google, and we'll see who chose a better company after five years." Chances are, they both will own Apple and Google and a whole lot of other large companies as well.

So, investors who build their investment foundation upon mutual funds are resting upon a foundation not of business selection, but of market movement. The mutual fund may move from one sector to another sector during the year (as the manager predicts better or worse performance for this or that sector during the next few months), but this is more a system of predicting markets (or slices of markets) than of analyzing companies (for a discussion of the fact that index funds by definition are built on a foundation of markets rather than companies, see our commentary entitled "The Emperor's New Index Fund").

The growing size of the pools inside individual mutual funds can also lead towards increased portfolio turnover in some (although not all) mutual funds. Because they own a huge number of identical companies as those held by everyone else (not because they want to, but because of the forces described above), they cannot differentiate themselves by owning different companies. Instead, in a very competitive marketplace, they can differentiate themselves by owning the same company but for a different quarter than their competition owned it.

In other words, they realize that they own Apple and their competition owns Apple, but they will differentiate themselves by owning it for a better quarter or two than their competition owned it -- creating higher turnover in some cases, as well as creating a tendency to focus on short-term events rather than on the long-term business outlook for a company over a period of many years.

In short, investors should be aware of the fact that the further they are from owning companies directly, the more likely it is that their investment philosophy tends to be rooted in market-timing activities rather than in lining their fortunes up with the long-term performance of exceptional companies. And, as we explained in this previous posting, most of the big fortunes in this country (over the past twenty years as well as over the past one hundred years) have been made by lining up with successful companies for a period of several years.

For later posts dealing with this same subject, see also:


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