Bruce Berkowitz’s Fairholme Fund earned big headlines at the close of Q1, as his stock picking prowess was cited as the source of a 31% return for the quarter and presumably put his fund back on track to continue its long term outperformance versus the S&P 500. How do we get under the hood of Fairholme to understand this relatively unusual fund a little better?
Fairholme is considered a “Large Value” Fund by Morningstar, with the S&P 500 as the stated benchmark. However, a basic style map shows that over the years the fund has behaved much more like a midcap product than either a large value fund or the S&P. It also has high correlation to midcaps. However, it has a low r-squared to the midcap index (and a similarly low r-squared to the S&P or other large indices). What’s going on?
A returns-based analysis of the asset allocation over time shows that the performance of Fairholme is basically a series of strong sector bets, which have varied during different cycles. We can see this by changing the indices used for the returns-based allocation analysis to the GICS sector indices, a less common but perfectly reasonable application of sound benchmarking principles as laid out by Sharpe. The chart below shows Fairholme's allocation (on top) vs. the S&P 500.
When you buy Fairholme, you are buying the ability of the fund manager to make bold bets that may vary from any index considerably. For example, at one time, Fairholme had a large bet on Consumer Staples. Now the bet is on Financials. This is made more clear by looking at allocations at various points in time (below), as compared to the rolling allocations shown above.
You are buying a manager who has conviction on a relatively small number of positions, and those positions are likely to be concentrated in sectors. Sometimes, those bets have not worked, as shown by the maximum drawdown chart, where Fairholme still has not recovered and has underperformed the S&P.
But, these days, Fairholme’s bet on a small number of financial services and financial-engineering driven companies has worked.
Returns-based analysis confirms what Berkowitz would probably say about his own fund: you are hiring him for his research and idiosyncratic, high-conviction approach. Some active managers are criticized for being “closet indexers” with portfolios of so many securities, their funds effectively become their index. With Fairholme, you may run other risks, but closet indexing is unlikely to be one of them. Rather, with Fairholme, you are clearly setting yourself up for ample excess returns, or losses, versus any broad market index.
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