Focus on These High-Concentration Funds

You're probably used to hearing about the importance of diversification in your portfolio. "Hold too much in a given stock or sector, and you're asking for trouble if that stock or sector tanks," you've been told time and time again. 

Yet that's just what some of the better actively managed funds do (along with some that are not so good). They put together highly targeted portfolios aimed at capitalizing on strong individual performances of a handful of stocks as opposed to casting a wide net and riding the market higher or lower. Although such concentrated funds might not make good core holdings for nervous investors because of their frequently above-average volatility, they can still serve as strong supporting players in a well-diversified portfolio. One common characteristic of concentrated funds can also be an advantage: They typically do not mirror the broader market, allowing fund managers to outperform by overweighting stocks or sectors they like.

The average stock fund contains well more than 100 different companies, allowing managers to hedge their bets by diversifying within and across sectors. With a more concentrated fund, the fund manager is under greater pressure to pick winners simply because he or she is placing fewer bets, with each one taking on greater significance. As such, the role of the fund manager and research team is magnified because of the importance of every stock selected. Just a couple of bad bets in a concentrated fund holding 20 stocks can affect 10% of the portfolio (assuming all stocks are held in equal proportion) or more.

A case study of what can go wrong with a concentrated fund is  Fairholme (FAIRX). The popular large-value fund easily outperformed the market during the 2008-09 downturn and subsequent rebound, but its heavy overweighting in financials led to a disastrous 2011 in which it lost 32.4% while the broader market gained 2 percentage points. (The fund has since recouped some of that loss, gaining around 30% so far this year as financials have recovered.)

To identify concentrated funds with good managers with strong track records and support teams, we used Morningstar's  Premium Fund Screener tool and searched for no-load stock funds with portfolios of 40 stocks or fewer and Gold or Silver Morningstar Analyst Ratings. We also screened for managers who have been in their current jobs for at least five years, to add an element of experience and stability. Premium users can see the full screen  here. Below are two of the funds on the list.

 Sequoia (SEQUX) (
)Although this large-blend fund achieves some extra diversification from its second-largest holding,  Berkshire Hathaway (BRK.A) (BRK.B), its portfolio of 34 stocks still places big bets on relatively few names. Its top holding,  Valeant Pharmaceuticals (VRX), represents nearly 11% of the portfolio, with Berkshire Hathaway at about 10%. Other top holdings include off-price retailer  TJX Companies (TJX) and fastener-distributor  Fastenal (FAST), at around 6% each. Managers Bob Goldfarb and David Poppe had about one fourth of the $5.7 billion fund's assets in cash at the end of last year and focus on high-quality companies with talented management teams. The fund's low 3% turnover rate speaks to its buy-and-hold mentality, and its top-4% performance in its category for the past one-, five-, 10-, and 15-year periods speaks for itself. The fund's stellar return statistics testify to management's skill, but new investors should go in with full recognition of the fact that concentrated funds like this will endure periodic weak patches. Dollar-cost averaging will help ensure that new investors don't buy into the fund at a high point. 

 Oakmark Global Select (OAKWX) (
)The comanagers of this world-stock fund are among the best in the business, with 2011 Morningstar Domestic-Stock Manager of the Year nominee Bill Nygren handling its U.S. holdings and David Herro, Morningstar's International-Stock Manager of the Decade, holding down foreign-stock duties. They look for companies with strong fundamentals selling at discounted prices. Roughly half of the fund's stocks are outside the U.S., with an emphasis on technology (30% of the portfolio) and consumer cyclical (21%) issues. The fund's concentrated portfolio of 20 stocks is led by  Toyota (TM) (6.6%). Oakmark Global Select has outperformed in both up and down markets, and, despite some rough patches, it ranks in the top 10% of its category with a five-year annualized return of 2.4%.

Performance data as of April 16, 2012; portfolio data as of Dec. 31, 2011.