Are 'Concentrated Funds' for You?

Funds that hold few stocks have certain benefits -- if you're ready for risk.
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Are you ready to invest in concentrated mutual funds?

Here's one way to find out: Hop a plane to Vegas and take a few spins at the roulette wheel. If you find yourself spreading your money evenly over all the numbers, then concentrated funds might not be your game. However, if you stack your chips on a few select numbers, then such funds might be for you.

Concentrated mutual funds hold a small number of stocks, which are generally limited to just a few sectors that the manager thinks will outperform the rest of the market. As with any more risky strategy, you can win big, but these funds are also much more volatile than broader market funds.

In the past few months, such funds have been performing well. Phil Edwards, managing director of fund research at Standard & Poor's, expects concentrated fund holders to see outsized returns when they open up their statements from the last quarter. Nevertheless, Edwards warns against market-timing concentrated funds or chasing performance. "The big risk in concentrated mutual funds is volatility," says Edwards. "You have to be patient and stick with it over long periods of time in order to realize the rewards."

Edwards documented those rewards last April when he released an S&P study that showed that concentrated funds outperformed nonconcentrated funds over a 10-year period by almost a full percentage point.

Edwards recommends concentrated mutual funds for investors "who have a tolerance and appetite for risk and a longer time horizon." His top concentrated fund choices:

(HACAX) - Get Report

Harbor Capital Appreciation Fund,

(TGCEX) - Get Report

TCW Select Equities and

(SBLGX) - Get Report

Smith Barney Large Cap Growth Fund.

Stephen Coleman, chief investment officer at Daedalus Capital, a St. Louis-based firm specializing in separate accounts, tells his investors that "the key to understanding risk is thinking in terms of time." He considers investing with a time horizon of less than three years to be "speculating."

That's not to say that Coleman isn't proud to trumpet his short-term results. Since Jan. 1, his fund has risen to $40 million from $28.7 million, and this comes after a phenomenal 112.79% return in 2003. The fund's success is mostly due to his "focused equity management" approach that limits holdings to no less than 10 stocks and no more than 25 stocks. His fund's performance is also a function of his decision to pick up some fallen telecom angels such as

Nortel

(NT)

when they were at their postbubble lows.

But life wasn't always buying Nortel at 75 cents,

Corning

(GLW) - Get Report

at $1.99 and

Charter Communications

(CHTR) - Get Report

at $1.25 before watching them grow exponentially.

Coleman saw the downside of concentrated equity funds in the two weeks after the Sept. 11, 2001, terrorist attack. Daedalus funds lost 50% of their value because of his tech-heavy holdings, which included

Sun Microsystems

(SUNW) - Get Report

and

Oracle

(ORCL) - Get Report

. Facing a seriously depleted portfolio, Coleman abruptly switched to defense and oil stocks, and stayed defensive until he started seeing value in telecom again in September 2002.

Neil Hennessy, portfolio manager of the

(HFTFX)

Hennessy Focus 30 Fund, doesn't view concentrated funds as having significantly more risk than well-diversified funds. In fact, he finds a number of advantages in keeping the names in his portfolio to a minimum.

"We have plenty of diversification with 30 stocks," says Hennessy. "Other funds have 200 stocks, but how can you cover all those companies? You can't possibly know all those companies that well." Hennessy also offers the customer's point of view: "Would you want a money manager to give you his 158th best idea?"

Point taken. But Hennessy also has the luxury of running a quantitative fund that chooses its top 30 picks on a seven-step screening process that includes a price-to-sales ratio below 1.5 and positive three- and six-month relative strength.

Aside from paying attention to his quantitative hurdles, Hennessy safeguards his concentrated portfolio by keeping the weight of each stock under control.

"We only put a maximum of 3.3% of our portfolio into any one company," says Hennessy. "So even if a company went broke, it would not cause a maximum amount of harm." Hennessy rebalances his portfolio on a yearly basis by trimming stocks that have run too far above the 3.3% threshold.

Once again, it takes time to tell the success of a concentrated fund, but for now, Hennessy is showing strong results. His $48 million fund is up 7.2% year to date.

Another question that springs to mind when considering concentrated mutual funds is the cost: How much should investors pay for a portfolio manager to watch a minimal amount of stocks?

S&P's Edwards doesn't view a mutual fund's costs as a function of the number of stocks that a portfolio manager needs to keep an eye on. In Edwards' opinion, it's the old question of active vs. passive fund management.

"Why pay higher fees for active management? At S&P, we see benefits of both active and passive investing. During some periods, passive investing has beaten active. In other periods, the opposite is true," says Edwards. "So an interesting strategy may be to use passive funds'

indices for the core of a portfolio and active concentrated funds,

since they have done better than diversified funds over long periods at the edges of the portfolio. Rather than an 'either/or,' combine the two strategies to get the best of both worlds."

Max Rottersman, founder of the mutual fund advocate Web site

Fundexpenses.com, agrees with Edwards' characterization and also agrees with the camp that says sometimes "less is more" when it comes to stocks in a mutual fund.

"Too many stocks and you might as well be an index, because you're so diversified," says Rottersman. "The idea of active management is to beat the market. Too many stocks and you just can't do it, because everything is watered down. Anyway, you don't need that many stocks to reduce risk."