The Case for Concentrated Funds

So far this year, stock funds with less than 40 holdings are beating their more diversified brethren.

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The famous volatility of concentrated stock funds is paying off big time, at least for now. So far this year, stock funds with fewer than 40 holdings have made a strong rebound. With an average return of 25 percent, they are beating funds with more than 40 stocks, which had returned an average of 21 percent as of October 31, according to Morningstar.

Over the long run, however, there is no clear winner between concentrated funds and more diversified funds that spread their bets among a larger number of stocks, says Karen Dolan, director of fund analysis at Morningstar. According to Morningstar data, the average five-year annualized return for funds with 40 or fewer stocks is 1.06 percent, very close to the 0.91 percent return for funds with more than 40 stocks.

Since concentrated funds have fewer holdings, individual stocks can weigh heavily on performance, Dolan says. For example, Legg Mason Value Trust, a concentrated fund run by Bill Miller—and the only mutual fund to outperform the S&P 500 for 15 consecutive years—plunged 55 percent in 2008 after investing in a "graveyard of financials" including Bear Stearns, AIG, and Freddie Mac. Mary Chris Gay, the fund's assistant portfolio manager, says it's important to recognize that if a fund doesn't look like the market—hugging the S&P 500, for example—it won't behave like the market. So at times, concentrated funds can pull far ahead of the market, but they also can fall much further in a down market.

Also called focused or select funds, concentrated funds typically have 40 of fewer stock holdings and tend to invest between 50 and 60 percent of their assets in their top 10 holdings, says Dolan. She adds that some funds that focus on certain sectors—like technology or healthcare—are also considered concentrated. "If you use the S&P 500 or a market index as your base line, any fund that's going to start pushing you toward bigger and biggest positions in either a specific stock or a specific sector classifies as a concentrated fund," she says.

Because of their volatility, concentrated stock funds tend to work better as a supportive player in a portfolio—accounting for about 5 to 10 percent of assets—but not a core holding, says Adam Bold, founder of the Mutual Fund Store. "They should be the icing on the cake, not the cake itself," he says.

One of the strengths of concentrated funds is that managers track fewer stocks, so they get to know the individual companies well, Dolan says. Richard Barone, manager of the deep-value-focused Ancora Special Opportunity Fund (ANSCX), says that a manager can't really be expected to focus on 250 or more companies. "If the manager can pick 25 or 30 of those companies, I think it demonstrates the skill of that manager," he says. Ancora, with 27 holdings, is the top-performing nonleveraged concentrated fund so far this year, according to Morningstar. As of early November, the fund was up more than 70 percent, a strong rebound from its 46 percent loss in 2008. The fund got a boost from Gannett Co., which recently traded at $10.56 a share. The managers bought the stock for $2 a share in March 2009. Gannett currently makes up about 2 percent of Ancora's assets.

Although Legg Mason Value Trust suffered from Miller's stock picks in 2008, the fund—which has held as few as 30 stocks and as many as 60—is up about 35 percent so far this year, which ranks it among the top 10 percent of its peers. This performance has been fueled by Miller's picks in the consumer discretionary sector, such as eBay, Amazon.com, and Sears Holdings Corp. And financials, which pulled the fund down last year, also are lifting the portfolio.