By Jonathan Burton, MarketWatch
SAN FRANCISCO (MarketWatch) -- The best stock mutual-funds often don't own many stocks.
Focused funds -- portfolios with only a couple of dozen holdings -- are getting attention in a market where stock selection is more important than ever. Their concentrated strategy might be worth some extra risk for investors who know what to look for.
"It's very hard to find 100 great investment opportunities, but there can often be 20," said Charlie Bobrinskoy, co-manager with Tim Fidler of Ariel Focus Fund /zigman2/quotes/209070886/realtime ARFFX +0.52% , which holds 23 stocks and sinks about half of its assets into its 10 largest positions. "Why put your money into your 100th or 50th best idea, when you can put it into your 6th or 19th best?"
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Good question, but one fund investors usually don't get to ask. Most stock funds focus on diversification, and that means spreading assets across a wide field. The average stock fund has 172 holdings, according to investment researcher Morningstar Inc. The typical focused portfolio, meanwhile, tends to just 25 names.
Risk and return
There's a reason so many stock funds are spread thin. Diversification is a tested way to control risk -- a stock that represents 1% or less of a portfolio can't inflict as much damage as a 5% position. Plus, owning a broad group of unrelated investments can smooth a portfolio's volatility over time.
Diversification's downside is that it limits a fund's chance to meaningfully outperform its index. Moreover, an overly diversified portfolio can mimic an index fund, but at a much higher cost. And diversification doesn't guarantee safety: When most every market sector crumbled last year, plenty of fully invested, diversified stock funds lost as much or more than their benchmarks.
Focused-fund managers tackle investment risk more proactively. They have to, because there's little room for error. So they emphasize in-depth stock research -- digging into a company's business and the quality of its finances and management, looking for the top prospects in myriad industries. And as an extra cushion, managers buy shares at a steep discount to what they believe they're actually worth.
"It's better to keep one basket and really watch that basket," Bobrinskoy said. "We've always been intrigued by Warren Buffett's statement that if you could make your 20 best investments, you would do really well."
The challenge of focused investing is that it requires more patience than many shareholders realistically have. Concentrated funds march to their own drummer. Because they've done so much spade work, focused managers tend to own stocks for longer periods than their more traditional peers. This low turnover reduces volatility and improves tax-efficiency. In addition, buying out-of-favor issues at a discount provides what pioneering value investor Benjamin Graham dubbed a "margin of safety" if a stock takes longer than expected to appreciate.
"If you know your companies extremely well and pay the right price for them, you have an advantage as it relates to managing risk," said Joe Wolf, a co-portfolio manager of RS Investors Fund /zigman2/quotes/209038662/realtime RSINX +0.36% , which owns 22 stocks.
Hits and misses
Yet having the courage of conviction means a focused fund -- and its shareholders -- are more exposed to the raw elements of the market. Accordingly, some years these funds will be wildly successful, but in others they will trail badly.
"You're not going to perform along with the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.08% ; there are going to be periods where you underperform -- and perhaps not by a little," said Adam Strauss, co-manager of Appleseed Fund /zigman2/quotes/201743997/realtime APPLX +0.18% , which limits itself to 25 mid- and large-cap stocks.
A celebrated case in point is Oakmark Select Fund /zigman2/quotes/207233272/realtime OAKLX +0.31% , a value-conscious portfolio with respected manager Bill Nygren at the helm.
To create the Select portfolio, Nygren winnows the less-concentrated Oakmark Fund /zigman2/quotes/203815081/realtime OAKMX +0.29% to about 20 high-conviction names, with almost 60% of assets in the top-10 holdings.