There are definitely plus and minuses of this focused strategy, as it helps you out perform, but without capital risk management, you could under perform by a wide margin as well.
- Scan the list of the worst-performing mutual funds of 2011, and you will run across a slew of formerly highflying fund managers whose picks have crashed and burned. The Fairholme Fund, managed by renowned investor Bruce Berkowitz, has lost more than 27% this year, according to investment-research firm Morningstar. Ken Heebner's CGM Focus has lost more than 22% and Bill Miller's Legg Mason Capital Management Opportunity has dropped almost 35%.
- A common thread runs through the failures. Each manager's fund owns fewer than 50 stocks or has more than half of its money tied up in its top 10 holdings. Such so-called focused funds are designed to let star managers shine. Instead of being bogged down in hundreds of stocks, where even a great pick will have only an incremental impact on the fund's return, the manager can home in on the few companies he or she is most excited about.
- When those picks outperform, the manager is a hero. Morningstar named Mr. Miller "domestic stock fund manager of the year" in 1998. Mr. Berkowitz was "domestic stock fund manager of the decade" in 2010. But just a few sour picks can cause such funds to plummet.
- This year, Mr. Berkowitz's Fairholme has been hurt by its 17% allocation to American International Group, which has lost more than half its value. The fund also holds significant stakes in Bank of America (down 53% year to date) and St. Joe (down 30%).
- "If you concentrate your assets, you must really believe in your idea," says Emory assistant finance professor Klaas Baks. "You can see that in better returns." In the meantime, a manager's strong conviction in the eventual salvation of a company can lead to wild swings in performance.
- Legg Mason Capital Management Opportunity shot up more than 84% in 2009. This year, the fund's share price has dropped by more than a third.
Here is another key reason it helps if a manager tries to mitigate wild swings:
- ....some investors won't have stuck around for the rebound. That is because they tend to get out of funds after bad years and dive in after good ones, often after the rebound has run its course.
- CGM Focus, for example, has made almost 10% annually over the past decade, but the fund's shareholders have lost more than 7% annualized through September, according to Morningstar. The firm calculates investor returns by incorporating the effect of money flowing into and out of the fund as shareholders buy and sell.