Buying a fund with a limited number of holdings is similar to picking a bunch of individual stocks-except that you don't pick those stocks yourself. Focused-fund managers often run these portfolios in addition to managing more diversified funds. Their focused funds are those in which they invest heavily in their favorite stocks or "best ideas," without worrying much about diversification or risk control. These managers usually argue that they're better able to generate superior returns by closely following a handful of top-quality stocks rather than a large collection of names.
For example, the highly concentrated Fairholme Fund enjoyed a nearly uninterrupted string of top-tier annual performances through 2010, but it stumbled in early 2011 with its nearly 90% stake in financials weighing it down. Although fallen angels such as AIG (AIG) and Citigroup (C) (both in the fund's portfolio) rebounded nicely in 2010 after the financial crisis, they came back to earth in early 2011, with the fund landing in the basement of its category over that short time period. Given manager Bruce Berkowitz's contrarian approach and concentrated bets, periods of poor returns are inevitable, even though the fund's longer-term record is stellar. That means funds such as Fairholme require far more conviction and patience than most in order to pay off for investors.
Given the added risk of investing in a focused fund, consider your own tolerance for short-term volatility. Would you be comfortable owning a fund that loses several percentage points in a matter of days? Could you stomach owning a fund that severely underperforms its category for a year or more? Even risk-tolerant investors will probably only want to buy a focused fund for a well-diversified portfolio and relegate it to their portfolio's most aggressive spot. Concentrated funds can be particularly useful counterweights to S&P 500 index funds or other broadly diversified funds.
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