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Don't Get Sucked in by Fairholme Fund's Great Long-Term Record

Manager Bruce Berkowitz is smart as a whip, but his fund’s extreme concentration and volatility make it inappropriate for most investors.

Bruce Berkowitz is one of the smartest investors I know. But that’s not enough reason to invest in Fairholme Fund (symbol FAIRX), which has just reopened to new investors.

Brains count for a lot. You need to be an independent thinker to be a good investor — and on this score, Berkowitz excels. But to run a mutual fund for individual investors, you also need to employ a strategy that will retain investors, and here Berkowitz falls short. (Berkowitz, who has managed Fairholme since its launch in 1999, declined through a spokesman to be interviewed for this article.)

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Berkowitz is a deep-value investor who studies stocks with utmost care. I admire him for his painstaking work. He rarely trades. Turnover last year was a mere 1.6%. In fact, he changes co-managers almost more often than he buys and sells stocks. Berkowitz lost four co-managers in one four-year stretch and is now Fairholme Fund’s sole manager.

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While some funds hold only 15 to 20 stocks, Berkowitz takes concentration to an extreme. As of May 31, more than two-thirds of Fairholme’s assets were in just three stocks. American International Group (AIG), the insurer that played a leading role in the 2008 financial collapse, accounted for a stunning 48.2% of the fund’s assets. Another 13.6% was in Bank of America (BAC), another poster child for the 2008 crisis that subsequently recovered, albeit with the help of a federal bailout. And 8.4% was in Sears Holdings (SHLD), the troubled retail chain. Fairholme only owns 11 stocks, and 76% of its stock money was in financials.

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Given the concentration and Berkowitz’s predilection for controversial stocks, Fairholme’s performance has been pretty much what you’d expect: erratic. In 2010, the fund returned 25.5%, beating Standard & Poor’s 500-stock index by 10.4 percentage points. In 2011, the fund plunged 32.4%, trailing the index by an astounding 34.5 percentage points. Last year, Berkowitz gained 35.8% — more than double the S&P. So far this year, Fairholme has returned 19.6%, edging the S&P 500 by 1.8 percentage points (all returns in this article are through August 26).

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What would you expect individual investors to do with such volatile returns? In 2010, assets swelled to $18.8 billion. In 2011, they plunged to less than $7 billion, suggesting a massive investor exodus. Today, even with big investment gains in 2012 and 2013, the fund has only $7.9 billion.

Fairholme’s long-term results are dandy. Over the past ten years, it returned an annualized 11.1% — an average of 3.7 percentage points per year more than the S&P 500 and good enough for the fund to rank in the top 1% of large-company value funds.

But the average investor in the fund hasn’t done half that well. According to Morningstar, the flows into and out of the fund were so poorly timed that the average investor earned only 4.4% annualized.

Is that Berkowitz’s fault? After all, he didn’t buy and sell at the wrong times. But he ran the fund in such a way that it was bound to happen.

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What’s more, in my view, this fund is positioned to crash and burn again in the next bear market. Fairholme is 75% more volatile than the S&P. I’ve never seen a fund that didn’t ultimately pay for its high volatility.

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Last February, stunned by poorly timed redemptions that forced him to sell shares in stocks he liked, Berkowitz did the right thing: He closed the fund to new investors, thereby stemming the flow of hot money.

Then on August 19, he did the wrong thing: He reopened the fund to new investors. Berkowitz told the Wall Street Journal that he sees opportunity in Fannie Mae and Freddie Mac, the mortgage giants that were seized by the government during the financial crisis. He already has investments in both.

Berkowitz may turn out to be right on this bet. But given the political gridlock in Washington, even if he is right, I wouldn’t expect any constructive government action that would boost the share prices of Fannie and Freddie until at least 2017.

All in all, Fairholme is a good fund to watch for entertainment value and to see what Berkowitz is up to. But don’t be tempted to invest in it. It’s too risky. Berkowitz should close it for good to new investors.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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