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. (For more background, see An Introduction To Sector Funds.)
As an illustration, consider the chart below comparing the Blackrock Global Financial Services Fund A. If an investor had invested in the Blackrock Global Financial Services Fund A at its low in 2003, he or she would have received a return of over 100% by its high in 2006. However, from that point forward the gains were quickly lost during the financial crisis of 2007/2008. During this time, most sectors, and the market in general, faired better than the financial sector fund.
- Value-Focused Funds
These value 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. (To learn more about value funds, see our Mutual Fund Basics Tutorial.)
Higher returns, however, are gained only with the acceptance of higher risk. An investor who chose to purchase the fund (below) at the beginning of 2006, when the price was $19.06, would have gained approximately 20% to its high in July 2007. However, the gain quickly reversed to bring the value back to under $10 in November 2008. As of September 2008, Artisan Mid Cap Value Fund had 47 holdings, with over 60% being in the business services, financial services, and industrial materials sectors.
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!