Finding an appropriate asset mix with the right level of risk for your portfolio can be difficult, but many types of mutual funds can help you achieve the right balance. The focused fund is one type that has gained investors' interest over the years. Managers of focused funds believe that it is better to concentrate a portfolio's assets to a small number of stocks considered to be high quality. Focusing on relatively few investments can reduce the required research, but a sharp focus has its consequences. Are focused funds right for you? Let's find out.

The Different Areas of Concentration

Sector-Focused Funds
These funds focus on stocks in specific sectors - such as biotechnology, pharmaceuticals or utilities - or in particular countries, such as Asia or Europe. Should the chosen sector perform well, the investment portfolio stands to gain a significantly large return. Consequently, if the sector is hit with bad news or other events that affect share price, the portfolio stands to magnify losses.

As an illustration, consider the chart below comparing the Jacob Internet Fund (red), with the S&P 500 (green). If an investor had invested in the Jacob Internet Fund in Feb 2000, he or she would have received a return of approximately 20% by the end of Mar 2000. However, from that point forward the losses magnified against the market in general. Even the tech-heavy Nasdaq faired better than the internet sector fund.

Value-Focused Funds
These funds tend to be created when fund managers of a normal portfolio believe that some of the portfolio's stocks are of higher quality. Seeking to maximize returns by focusing specifically on those choice stocks, these fund managers may decide to focus specifically on 10 to 30 stocks or to concentrate a large portion of the portfolio to a few stocks.

Higher returns, however, are gained only with the acceptance of higher risk. At the beginning of Jul 2002, the Liberty Acorn Twenty Z Fund, for example, held 23 stocks. An investor who chose to purchase this fund during the that time, when the price was $14.40, would have lost approximately 15% towards the end of the same month. However, the loss quickly reversed to bring the value back to $14.50.

Magnified Funds = Magnified Costs?
Just as focused funds may magnify value and returns, they could magnify your losses and costs. Costs are extremely important to consider when choosing funds for your portfolio. On average, sector funds tend to charge higher fees due to management expertise. These costs eat into your return, turning the high returns advertised by fund companies into a loss or a very small gain. It is almost always a good policy to avoid funds that charge loads and 12b-1 fees. If the fees are impossible to avoid, try to stay away from funds with management expense ratios greater than 2%.




Diversification vs. Under-diversification
Maintaining a diversified portfolio has almost always proven itself to be an excellent investment strategy for managing risk. (For further diversification illustrations, see The Importance of Diversification.) Under-diversification exposes the investor to greater risk and larger price fluctuations.

At first glance, value funds holding 10 to 30 stocks appear to follow the widely accepted optimal diversification strategy, which aims for a portfolio of approximately 15-20 stocks. In many instances, however, value funds tend to invest within the same sectors and, as such, deviate from the conventional optimal diversification strategy. Diversifying across sectors is integral to reducing the amount of risk your portfolio holds since events that affect one sector will not have the same effect on other sectors.

Risk tolerance of investors varies, so be sure to choose funds that are in line with your own tolerance. Focused funds can create additional returns for your portfolio; however, putting all your eggs in one basket could also expose you to great losses. Caveat emptor!

by Shauna Carther, (Contact Author | Biography)

Shauna Carther is the vice president of content at Investopedia.com. In 2007, she appeared as a guest on Moneytrack, a Public Broadcasting Service program devoted to helping consumers learn to invest and take control of their finances.