The Risks and Rewards of Concentrated Funds

Should you invest in funds that bet big on a single company?

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To say that Bruce Berkowitz, the manager of the famed Fairholme Fund, likes AIG would be an understatement. As of the end of August, the fund (symbol: FAIRX) owned more than 80 million shares of the insurer. That single position accounted for more than 37 percent of the fund's portfolio. In another one of Berkowitz's funds, Fairholme Allocation (FAAFX), the company MBIA, also an insurer, took up nearly 30 percent of the portfolio as of the end of August.

While Berkowitz is perhaps the highest-profile practitioner of the concentrated portfolio, he is hardly alone. According to data from Morningstar, there are more than 50 stock mutual funds—most of them active, but some tied to indexes—in which a single investment represents at least 15 percent of the total portfolio.

[See: 7 Mutual Funds That Make Huge Bets.]

Many of these funds are heavily invested in large, well-known companies. For instance, in 17 of the funds identified by Morningstar, the holding accounting for at least 15 percent is Apple. However, some funds are making hefty bets on lesser-known names. Take, for instance, Touchstone International Value (FSIEX), which as of the end of October had more than 30 percent of its portfolio tucked away in Central Japan Railway Company. Or Prasad Growth (PRGRX), which as of the end of September had more than 20 percent of its portfolio invested in the mining company Uranerz Energy Corporation.

Such heavily concentrated portfolios come with their own unique challenges and opportunities for investors. "The risks and the benefits are two sides of the same coin," says Jeff Tjornehoj, the head of Americas research at Lipper. "When [the stock in which the fund is heavily invested] goes up in value, that has a significant effect of the value of the overall portfolio. And in contrast, when it stinks, you absolutely feel the pain."

[Read: Understanding Your Mutual Funds' Portfolios.]

For example, Steven Check, manager of Blue Chip Investor (BCIFX), has roughly a third of his portfolio invested in Berkshire Hathaway. "If you think you have pretty much a sure thing, there's almost no limit as to what you should put into it," he says. Check notes that while Berkshire Hathaway is technically just one company, its role as an overseer of various subsidiaries makes it more diversified than most standalone companies. "We wouldn't take such a big position in probably any other company, but we feel very comfortable with it in this case," he says.

Concentrated funds, however, are not for everyone. Russel Kinnel, Morningstar's director of mutual fund research, suggests that investors who are considering buying a concentrated fund should be prepared to hold onto it for a "bare minimum of 10 years." Such a long holding period is necessary, he says, to account for the fact that portfolios that depend so heavily on a single company can suffer from significant short-term volatility. "[The strategy] requires that people use it right," he says. "It requires that people be patient."

The Fairholme Fund's recent experience illustrates the potential for a rollercoaster ride. In 2011, AIG lost a painful 52 percent, and Fairholme investors acutely experienced that loss. Though the fund still has top-notch long-term numbers, it finished 2011 in the bottom percentile of Morningstar's large-value category—a testimony to the impact a single stock's performance can have on a concentrated portfolio.

[Read: 2012 Mutual Fund Scorecard: The Year's 5 Biggest Winners.]

Owning a concentrated fund also requires that investors put a great deal of faith in the fund's manager. Kinnel says that managers who make such large bets should have "greater proof of skill" and a "longer track record." When such seasoned managers are willing to commit to a company, investors will likely take note. "I think there's an attraction to managers who carry a lot of conviction in their portfolios," Tjornehoj says. "And by that, I mean they're willing to stake their reputations, their firms' profitability, and all that on just a few names."