Why Now Is the Time to Invest in a Focused Fund

This is the right time for investors to focus on mutual funds that do “less”—meaning they invest in a relatively small number of stocks. That’s the view of fund expert Todd Rosenbluth and many other investment strategists. Here’s why so-called “focused funds” are attractive now…

The Benefits of Concentrating

Most stock mutual fund managers create portfolios with many dozens or even hundreds of stocks with the aim of controlling volatility and avoiding disaster in case one stock or ­industry really craters. Overall, “active” fund managers (those who pick and choose stocks rather than just tracking an index) hold an average of 144 stocks in their fund portfolios and limit how much of the assets they devote to any single holding. But in many cases, that limits their ability to outperform the overall market.

This limitation may be acceptable at times when the overall market is achieving powerful gains, as it has for several years. When the market does great and you have invested in a fund that closely reflects the market, then you’re going to do great, too (even if you slightly trail the market, as many active fund managers have done in recent years).

But actively managed funds seem to have turned a corner after several years of lagging behind index funds. In the first six months of 2015, actively managed US stock funds returned 3%, on average, compared with 1.2% for the Standard & Poor’s 500 stock index, and 58% of actively managed funds beat their benchmark indexes. That’s no accident, and the trend will likely continue. As overall stock market gains slow down and bargains become scarcer, active managers have more room to outperform. And the likely prospect of rising interest rates beginning later this year could provide an additional boost. In past periods when interest rates were rising, actively managed funds outperformed the S&P 500 by an average of more than three percentage points a year.

These trends can be especially beneficial to the daring managers who drastically limit the number of stocks that their funds bet on. Managers of focused funds invest only in stocks in which they have the greatest conviction. They do not have to dilute their fund portfolios for the sake of ­diversification.

These managers also can dig more deeply into the limited number of companies they focus on, gaining a better understanding of the management and finances. However, because focused funds rely more heavily on the stock-picking skills of their particular managers, you must evaluate the managers ­very carefully.

HOW TO CHOOSE A FUND

Before putting money into a focused fund, make sure that you are comfortable with the fund manager’s strategy and that it has resulted in market-­beating long-term returns.

Some focused funds hunt for deeply undervalued stocks, rarely buying or selling and often holding high levels of cash. Others aggressively trade in and out of growth stocks and leave little in cash. Neither approach is ­guaranteed to succeed, but it’s ­important to ­understand the approach because it sheds light on how the fund performs at various times and how volatile it may be.

To benefit from a focused fund, you need to be patient and ready to stick with the fund for at least two years. These funds can be way out of sync with other funds and with the overall market for extended ­periods.

My Favorite Focused Funds

Some focused funds hold only a couple of dozen stocks, but to allow for more flexibility in creating this list, I have selected no-load funds that hold up to 45 stocks…that are highly ranked by my research firm, S&P Capital IQ, based on such factors as risk-adjusted performance…that are able to invest in multiple sectors of the market (which excludes single-sector funds)…that are open to new investors…and whose managers have well-defined strategies. Each of my ­selections outperformed the S&P 500 by an average of at least one percentage point annually in the 10 years through June 30…

Ariel Appreciation (CAAPX). Lead fund manager John Rogers invests like Warren Buffett invests. He looks for high-quality companies with strong brands that generate heavy cash flow. The fund can be very volatile because ­Rogers keeps two-thirds of the portfolio in mid- and small-cap stocks and is willing to put more than half of the assets in just a few sectors. Number of stocks: 39. Performance: 9%.*

Baron Partners (BPTRX). This ­aggressive mid-cap growth-stock fund hunts for innovative companies in fast-growing areas of the economy that fund manager Ron Baron believes can double their share prices in the next five years. He keeps about 70% of the portfolio in 10 holdings. Number of stocks: 26. Performance: 9.7%.

Brown Advisory Growth Equity (BIAGX). This large-cap growth-stock fund looks for companies with ­annualized earnings growth rates of at least 14% over five years, much greater than the long-term earnings growth rate of the S&P 500. Manager ­Kenneth Stuzin relies on what he calls “Darwinian Capitalism”—for every new stock the fund adds, an existing holding must be sold. Number of stocks: 33. Performance: 9.5%.

Hennessy Focus ­(HFCSX). David Rainey and two other ­comanagers run one of the most compact portfolios of any focused fund. They look for undervalued growth stocks of companies of any size whose annual earnings they can reasonably predict for the next ­decade. The managers temper volatility by holding large amounts of cash in the fund (10% or more of assets). Number of stocks: 22. Performance: 10.6%.

Janus Forty (JDCRX). Like many Janus funds, this large-cap growth fund focuses on companies that are dominating and changing their industries through disruptive technologies, products and/or business models. But fund manager Douglas Rao also mixes in various troubled companies that are in turnaround mode as well as some foreign stocks. The result has been big ups and downs from year to year but strong long-term performance. Number of stocks: 42. Performance: 9%.

Nicholas Fund (NICSX). Albert Nicholas has run this growth-stock fund for more than 40 years, beating the S&P 500 by an average of two percentage points a year. He avoids volatile sectors and seeks companies of various sizes with strong balance sheets that can grow steadily despite the ups and downs of the economy. Number of stocks: 45. Performance: 10.2%.

Parnassus Endeavor (PARWX). This large-cap growth-stock fund practices so-called socially responsible investing, excluding stocks that derive significant revenue from tobacco, alcohol, gambling and weapons contracting. Manager ­Jerome Dodson also favors companies that treat workers well. He reasons that such companies are able to recruit and retain better employees and perform at higher levels than competitors in terms of innovation, productivity and profitability. Number of stocks: 35. Performance: 12.1%.

*Performance figures are annualized returns for the 10 years through June 30, 2015, as calculated by Morningstar, Inc. The number of stocks is based on the most recent fund company filings.

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