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When it comes to diversification, the primary purpose is to eliminate security specific risk to the point where all you are left with is systemic risk. What many mutual funds aim to do is further reduce that risk by holding handfuls of securities. Balanced funds will hold cross-sector as well as cross-asset class securities while equity funds will hold cross-sector holdings. What complicates matters for a lot of mutual funds is the sheer amount of securities they hold. Not only is risk diversified away (or watered down) but gains can also get watered down. Why not hold an index fund, right?

Of course, a lot of equity funds will outshine the index, making them more attractive based on their performance record. One equity fund that has a long history of outperforming and is also one that gets quite a bit of attention is the Sequoia Fund (SEQUX), a 5-star fund as rated by Morningstar. And recently, it was mentioned in a Morningstar article about investment funds that show tremendous focus.

An Equity Fund With Concentrated Holdings

The idea with Sequoia is not to hold an index. This is a large cap growth fund, no misunderstandings about that. And when it comes to this often-dismissed capitalization group, what matters most is not the index as a whole, but those few big winners that will carry the fund. Indeed, Sequoia holds such a small number of securities (30 as of the latest fund filings) that the word focus sure comes to mind. But we see another word here: concentrated.

With so few holdings in a portfolio, there is plenty of concentration. And the way this can go is one of two ways: concentration of risk or concentration of returns. For Sequoia, this has for the most part translated into a concentration of returns. Perhaps not great trailing returns, but positive returns for all but the 3 years measurement, which at -2.45% still outperforms the Index at -7.01% (for the record, all measurements of trailing total returns beat the Index from a YTD basis on up to 15 years). So, would a Sequoia be happier with an index fund? Doubtful.

In speaking of returns, this fund is currently ranked ahead of all other Large Cap Blended mutual funds with a YTD return of 12.57%, a far cry from the average return of 3.21% for its peers and 3.89% for the index. Advantage: Sequoia.

This equity fund has a made it a habbit of outperforming the index, but over the past decade, it has underpeformed a total of 4 times. Twice, it underperformed by a wide margin (11.57% in 2003 and 11.08% in 2009). When it outperforms, it does so modestly (except in 2000, 2001, 2002 where it beat the index by 29.17%, 22.14% and 19.46% respectively).

Sector analysis becomes virtually worthless with such a concentrated mutual fund. What we will state is that Sequoia holds nothing in the following sectors: Software, Hardware, Telecom, Energy and Utilities; its Media and Business Services holdings are less than 2% and these holdings are either shrinking (such as Expeditors International) or are untouched. This leaves just a few sectors, including Consumer Services Financial Services which are the big weightings, with Healthcare, Consumer Goods and Industrial Materials filling up the rest.

What investors will really want to know is how this fund invests. With so few positions, virtually all securities are key holdings and almost all about 2/3rd of assets are in domestic equities (about 1/4 is in cash).

Berkshire Hathaway at 15% of holdings, YTD return of 23.8%

With Berkshire being similar to a tightly held mutual fund itself, it strikes us as odd that so much is riding on how well Berkshire performs. Perhaps it is because Warren Buffett is not a fund-manager-for-hire. But it could also be that Sequoia’s managers, who are well tenured, see the value that Berkshire offers its shareholders. Notwithstanding the tremendous returns that Berkshire has provided its shareholders, Sequoia has reduced its holdings here by roughly 1/3. While it is unfortunate on the one hand that they are reducing holdings in such a strong performer, it also means that this star fund will look for its next big winner and we are curious to see what that might be.

TJX Companies at 6.81% of holdings, YTD return of 23.8%

Another top performer, TJX (think of TJ Maxx and Marsalls), continues to benefit from tough economic conditions in the US. This has allowed the company to enjoy growth, mostly through new store openings. While many people expect to see sales growth slow (quite considerably in some instances), there is probably still some growth left here, especially as it expands internationally and continues to offer name-brand products at its stores. At 6.81% of holdings, the mutual fund has neither added nor decreased its position. This is prudent because margins on much of its product lines make it tough to compete with virtually all other retailers who are fighting for the same cost-conscious buyers.

Idexx Laboratories at 6.79% of holdings, YTD return of 15.1%

Idexx operates in an interesting and growing niche — the pet market. By manufacturing products that allow pet owners, who continue to incrase in numbers, to better care for their pets, they are carving themselves a deeper niche. Despite the economic struggles that we deal with domestically, Idexx has seen that pet owners are actually increasing spending on their pets — to the tune of a 100% increase. This, in turn, has allowed Idexx to continue reporting solid numbers. With 80% of its income coming from household pet products, the rest comes from the growing veterinarian/clinic area. Not a bad company, although Sequoia has neither added nor reduced its holding, signaling that it is quite comfortable with its present exposure here.

Overview of Holdings

Big gains from big holdings are not uncommon. In the top three security holdings above, all YTD returns were well into the low double digits. There are some holdings returning close to 50% for this mutual fund. Some of the losses are also reaching into double-digit territory.

Overall the Sequoia fund has taken very specific and concentrated positions in the companies it holds as part of its $3.2 Billion fund. To date, it has performed quite well, indicating that its analysis is fairly conservative and has yielded positive returns on the whole.

Our biggest concern is concentration of risk. Although many will argue that 9 to 12 securities are all that one needs in order to diversify away most risk, this fund is still taking fairly large leaps on the few holdings it has.

Who Should Own This Mutual Fund

As a large cap growth fund with the majority of holdings in domestic securities, Sequoia presents a decent opportunity for many investors. The risk is with the concentration of holdings in a period where economics remains unclear. Investors with enough experience and a need to take concentrated risks as part of their core, domestic equity holdings would be very smart to invest in this mutual fund, particularly if their satellite (or secondary) mutual funds see enough overlap.

For conservative investors who like the premise of this equity fund, a maximum exposure of 50% (as part of their entire domestic equity holdings) might be wise, with the remaining domestic equity holding in something more spread out.