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Course 403
Using Focused Funds

Introduction

Focused funds (also known as concentrated, compact, select, or nondiversified funds) have become very popular. Many fund families now offer at least one.

Should you buy one? And if so, what should you look for? Before answering those questions, let's examine what exactly we mean when we talk about focused funds.

What Are They?

There is no standard definition for focused funds. The most common reference point is the number of individual stocks a fund holds. Generally, a focused fund will hold fewer than 40 stocks, and some of the most focused funds, such as Oakmark Select (OAKLX), hold around 20 names. Find how many stocks a fund holds by checking its portfolio in its shareholder report or looking at the Portfolio section of its Morningstar fund report.

Numbers aren't everything: A fund can also be considered focused if it concentrates a large percentage of its assets in its top five or 10 holdings. (This style is a common byproduct of investment strategies that also limit the fund's number of holdings to fewer than 40 stocks.) Columbia Acorn Select (LTFAX), for example, is considered a focused fund; as of March 2011, it devoted nearly one fourth of its assets to its five largest holdings.

Finally, focused can refer to a diversified fund's sector exposure. Some funds concentrate in only one or a few market sectors. For example, CGM Focus (CGMFX) invests a lot in some industries, such as technology and energy, and 0% in others, such as consumer defensive, health care, and utilities (as of March 2011). Sometimes, but not always, funds can become focused by sector because they own few individual stocks.

Why Would You Want One?

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.

What to Look For

If you think your investment portfolio could use a focused fund, look for the following five qualities before you buy.

Experienced management Because so much rides on the individual stocks in a focused fund's portfolio, it is crucial that you look for a fund run by a seasoned manager. Few fund managers cut their teeth on a focused fund. Usually, they get their start in the industry running fairly well-diversified portfolios. Look at the performance and risk records of the funds the manager has run in the past. Did those funds produce better performance than their category peers? It's even better if a manager already has a long and solid record running a focused fund.

A reputable fund family In conjunction with an experienced manager, look for focused funds from proven fund families. Some firms are better known for their stock-picking ability than others, and families that offer extensive research capabilities are probably a good bet. Also, look for a fund from a family known for its quality control. Does the family tolerate long periods of underperformance? Or does it take action, as Vanguard does with its subadvised funds when it sees something it doesn't like? (A fund is subadvised when the company offering the fund hires outside managers to run it. Vanguard does that with many of its non-index equity funds.) Families with reputations to protect are likely to be more vigilant than recent startups that have nothing to lose.

Strong long-term performance You may be attracted to a focused fund because of a great quarter or sensational year. But because focused funds are linked so tightly to a few stocks or sectors, most of them will have a few glory days. Instead, look for a fund that has done well over time. If managerial experience at a previous fund is not available, then make sure the fund you're interested in buying possesses at least a solid three-year record.

Modest expenses As with any other fund purchase, check the cost before you write your check. You should avoid any focused fund with an expense ratio higher than 2%.

Risk-busting approach Most focused funds are risky investments by their very nature, but even in this arena there are ways you can reduce risk. Consider a fund that follows a value strategy (or is at least valuation-conscious), rather than a growth strategy. Clipper (CFIMX) is a value-oriented focused fund. You might also consider a fund that's focused in its number of holdings but that has some sector diversification, making it less vulnerable to economic cycles.

Quiz 403
There is only one correct answer to each question.

1 Which of the following would not qualify as a focused fund?
a. A fund that owns 35 individual stocks.
b. A fund that has the exclusive attention of its manager.
c. A fund that invests 70% of its assets in its top-10 holdings.
2 In terms of risks and rewards, investing in a focused fund is similar to investing in:
a. An index fund.
b. A fixed-income fund.
c. A basket of individual stocks.
3 Which of the following should you expect when you invest in a focused fund?
a. Occasional short-term volatility.
b. An inexperienced manager.
c. High expenses.
4 Which is the biggest benefit of buying a focused fund from an established and reputable fund family?
a. Established fund families usually have the best managers.
b. Their funds are usually less expensive.
c. They will probably intervene if the fund underperforms over a long period of time.
5 Which focused fund should you be wary of?
a. A fund with 30 or 40 stocks.
b. A fund that concentrates in a few sectors.
c. A fund with a 2% expense ratio.
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