4 Things Investors Can Learn From Fairholme Fund's Struggles

The once-mighty Fairholme has lost about 22 percent so far in 2011.

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Bruce Berkowitz has racked up quite an impressive long-term record with the Fairholme Fund (symbol FAIRX). Over the past decade, the fund has returned a whopping 8 percent annualized, beating the average large-value fund by almost 6 percentage points per year, on average. Because of its success, Fairholme has caught the eye of many in the investing world. In 2009, Morningstar named Berkowitz one of its fund managers of the year, and later anointed him one of its managers of the decade.

Berkowitz has made a name for himself by making big bets on individual companies. In the early 2000s, he allocated a quarter of the fund's assets to Berkshire Hathaway, and in late 2008, Pfizer accounted for nearly a fifth of assets, according to a recent analyst report from Morningstar's Editorial Director Kevin McDevitt. Lately, Berkowitz has been betting big on financial stocks, but so far that strategy hasn't paid off.

So far in 2011, Fairholme has lost about 22 percent, landing it near the bottom of its category and sending investors fleeing from the fund. Fairholme saw net inflows of more than $4.3 billion in 2010, according to Morningstar, but that's been erased in the past five months, with $4.4 billion in outflows. It seems that some investors have found out the hard way that the fund's high-risk strategy may not work for them.

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Here are four lessons investors can take away from the Fairholme Fund's recent struggles:

Past performance is no guarantee of future results. You'll find this disclaimer in every mutual fund prospectus and advertisement. Just because a fund has delivered solid returns in the past doesn't mean it will continue to do so into the future. "Too often, investors focus on past performance, not necessarily thinking about the risks that are being taken on," McDevitt says.

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Contrarian investing can be painful. Fairholme's slogan is simple: "Ignore the crowd." Berkowitz's contrarian investing style involves buying beaten-down companies or stocks that are out of favor with the general investing public, then waiting for a turnaround. "Anyone who is a contrarian will inevitably be wrong for long periods of time," McDevitt says.

Before you invest in a fund, ask yourself if the manager's strategy suits your investing style. McDevitt says average investors should probably think twice before investing in a fund that strays far from its benchmark index and its peers because they'll likely be in for a wild ride at times. It can be difficult for investors to watch their investments underperform the market for an extended period of time without being tempted to sell.

Concentrated funds pose unique risks. If a fund is concentrated—meaning it has a relatively small number of holdings—it's not necessarily riskier than a broadly diversified fund. But concentrated funds exhibit a different type of risk, which hinges on what types of companies a manager favors. Funds like Fairholme take on a great deal of risk by investing in an extremely unloved area of the market. Berkowitz recently increased his exposure to troubled insurance giant AIG, which now accounts for 18 percent of the portfolio's total assets. About 75 percent of the fund's total assets are invested in the financial sector, which has been plagued by poor performance because of concerns about increasing regulations and worries of a global economic slowdown. As a result, the fund's performance will be highly correlated with what happens in that volatile sector of the market.

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Diversification is important. McDevitt says specialty funds like Fairholme should generally play a supporting role in a portfolio. "This should be more of a satellite holding than a core holding for most people, if they're even going to invest at all," he says. If you choose to invest in a fund like Fairholme, you should only do so after selecting a few core holdings for your portfolio that are more broadly diversified, McDevitt says.