By Paul Hughes
Quest Capital Strategies

Focused funds can be a rewarding part of an investor’s portfolio, but they have some added risk. Diversification, one of the best tools for reducing risk, is the best argument for investing in mutual funds. There’s an ongoing argument about how many stocks one must own to be truly diversified. Somewhere between 15 and 30 is the general consensus.

But an investor must have stocks in different industries too; owning 100 shares of stocks in each of 25 companies within the same industry can spell disaster if that industry falters. To be really diversified, one should have stocks in different industries. In theory, at least a few of an investor’s stocks will rise when the others fall.

Narrow Focus

So-called focused funds typically have fewer than 50 stocks in their portfolio, and often as few as 20. CGM Focus, the top-performing focus fund the past five years, maintains 20 to 25 stocks in the fund.

Focused funds can be a rewarding part of an investor’s portfolio, but they have some added risk.

Like many top-performing focused funds, CGM Focus concentrates its holdings in just a few sectors. It’s a winning strategy in a narrow market. For example, the Select Sector Energy SPDR, which tracks the energy sector, has gained 44.5% over the past 12 months, vs. a 15.5% gain for SPDRs, which track the S&P 500. A fund that focused mainly on energy stocks would have clobbered the S&P 500.

Not surprisingly, CGM Focus is well focused on energy and raw materials. CGM Focus has 57% of its assets in energy stocks and another big chunk in mining and steel stocks. All told, 93% of the fund is in energy, mining or steel.

So far, manager Ken Heebner’s focus on energy and raw materials has been correct. The fund is nimble enough that quick changes to the portfolio can be made as conditions change.

Running a focused fund forces the manager to concentrate. A manager with 300 stocks is likely to have a fund whose performance closely mirrors the stock market as a whole — minus expenses. On the other hand, a focused fund is less likely to track the broad market closely. This is good for diversification.

Volatility is the price of concentration. For an aggressive fund like CGM Focus, that produces big swings. Its beta is 1.5. That means the fund will probably gain 1.5% if the overall stock market gains 1%. If the market falls 1%, CGM Focus will likely lose 1.5%.

Value-oriented focus funds can pose similar problems. For example, the Yacktman Fund has 34 stocks in its portfolio; Yacktman Focused has just 19. The focused fund has 40% of its assets in consumer-goods stocks, such as Coca-Cola, and 16.8% in financial services stocks, according to mutual fund tracker Morningstar.

Less Volatility

Yacktman Focused is far less volatile than CGM — its beta is just 1.1% — but it’s still a concentrated fund. Like CGM, the fund can sometimes take big hits. Yacktman Focused, for example, lost 22% in 1999, in the midst of a raging bull market.

An investor may wonder if they are getting their money’s worth with focused funds. Hennessy Cornerstone Growth, for example, is admittedly a top-performing fund. It picks 50 stocks once a year.

The selections are based on a stock’s past year’s performance, its price, relative to earnings and several other factors.

The portfolio is rebalanced annually. Management’s fee is 1.23% of the fund’s $1.4 billion in assets each year.

A focused fund can add spice to an investor’s portfolio and be a decent  diversifier, too. Investors should not keep too much of their assets in any one focused fund; 10% of one’s stock portfolio should be fine for the average investor.

More adventurous investors may try 15%. More than 15%, though, and the investor’s decision might be regrettable.

Always work closely with your clients to ensure they fully understand their investment decisions. Recommend investment products that are suitable to their unique circumstances, which include age, income and risk tolerance.

They should invest for the long-term.