Three Flavors of Focused Funds

Some investors want their equity-fund managers to demonstrate conviction. They want managers to buy only companies in which they have the utmost confidence, not to go on and add scores of other names for the sake of supposed diversification. Though compact portfolios are in the minority, several well-known funds are among those relying on this "focused" approach.

Not all focused funds are alike, however. The managers of such funds can follow aggressive or conservative stock-selection strategies and provide varying amounts of diversification by sector or region. Even at the most basic level--concentration by stock--such funds can be very different in a way often overlooked by investors. A few managers who own a relatively small number of stocks raise their level of conviction even further by pouring assets into a handful at the top. Conversely, some others who buy a limited amount of names don't make large bets on any of them. Still others fall in between.

Any of these approaches can work well or fall short. But they do carry different types of risks. Therefore, even investors who want a focused fund must investigate the details of the portfolio itself, not just the number of holdings, when deciding whether or not a fund truly suits them.

The True Believers
A few intrepid managers not only focus on a small number of stocks, but also invest substantial percentages of their assets in their top picks. As a rough guide, these managers frequently invest around 10% of assets or more in their favorite stock and devote nearly as much to a few other holdings.

One of the most prominent funds, Fairholme Fund FAIRX, lands firmly in this camp. Its portfolio for Nov. 30, 2010, (the end of its fiscal year) had 11.5% of assets in General Growth Properties GGP, a daring play by lead manager Bruce Berkowitz that brought huge rewards. It also had 9.6% in AIG AIG, which helped greatly last year but in 2011 is a major reason why the fund is struggling. The fund's most recent portfolio has no double-digit positions. But last November's allocations were not anomalies. In November 2008, Berkowitz invested more than 18% of the fund's assets in Pfizer PFE, partly as a defensive play at a time of frightening market turmoil. (He later sold it, expressing some disappointment, but it did post a gain--he could have chosen much worse alternatives at the time.)

Ever since starting Oakmark Select OAKLX in 1996, Bill Nygren (and later his comanager) have commonly devoted stakes of 8% and more to a few companies at the top of the portfolio. In a storyline familiar to many fund investors, Nygren sank a substantial portion of Oakmark Select's portfolio in Washington Mutual for many years before the financial crisis, with stakes frequently topping 15% of assets. In the end that commitment backfired, but the fund has excellent long-term returns. While stakes of 15% are no longer in evidence at the fund, it will still take a stand: Discovery Communications DISCB received around 10% of assets for most of 2010.

The managers of Longleaf Partners LLPFX consider a 5% stake to be a full position, and wouldn't put 15% or 18% of assets in any name. But a "double position" of around 9% or 10% has often appeared in the portfolio when the managers feel they have spotted an exceptional opportunity. In the past five years, DirecTV DTV, Dell DELL, and Liberty Interactive LINTA are among the companies that have received greater than 9% of assets on one or more occasions. Dell has not paid off as the managers anticipated (at least not yet--it's still in the portfolio, with a smaller position.) But some of the others have been major successes.

When Focused Is Not That Focused
At the other extreme of the focused group lay funds that, while limiting the number of holdings, take care to spread out their assets across them. In such portfolios, positions rarely if ever reach even 5% of assets, let alone double digits. Why would a manager with enough confidence to restrict a portfolio to 40 or 50 names not want to make a bigger play on his best ideas? As one such investor told Morningstar, he's humble enough to know there must be one or two duds in the bunch--but he doesn't know which ones.