Mutual Funds: When Less is More

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By Mark Jewell, AP Personal Finance Writer

BOSTON (AP) — With mutual funds, sometimes less is more.

A fund holding just a couple dozen stocks might succeed in maximizing returns, with the manager's strong conviction behind each pick yielding better performance. The trade-off? Investors sacrifice the relative safety of the hundred or more stocks that many funds hold.

Of course, it doesn't always turn out that way for so-called "focused" or "concentrated" funds: Betting big on a few favorites can backfire if the picks are lousy.

But the approach has sure worked for Bruce Berkowitz, whose Fairholme Fund (FAIRX) has just 26 holdings. Morningstar on Tuesday named Berkowitz "Domestic-Stock Fund Manager of the Decade," noting that Fairholme beat the Standard & Poor's 500 by 14 percentage points over the past 10 years. As if that weren't enough, Berkowitz also won stock fund manager of the year honors for his terrific 2009.

Now, Berkowitz is trying to use his stock-picking reputation as a springboard into bonds, with this month's launch of another fund he's simultaneously managing: Fairholme Focused Income Fund (FOCIX).

It's an attempt to defy convention by a man who's lived by a concentrated portfolio manager's "less is more" mantra. Only a handful of bond funds have fewer than 80 holdings, according to Morningstar. But Fairholme Focused Income aims to hold just 15 to 50.

"Why in the world should I want to invest in my 30th best idea, if I can buy more of my best idea?," reasons Berkowitz, who started his career in fixed income before switching to stocks in the late 1980s.

That statement may sound like heresy to bond investors who typically seek safety and the reliable income generation that they can't get from stocks.

That's why many fixed-income funds hold hundreds of bonds. By spreading investments across many companies and bond categories, a fund and its investors take only a small hit in case of a default or collapse at one or two bond issuers.

Berkowitz isn't the only money manager trying to turn a concentrated portfolio approach into more than just a stock fund strategy. Last summer, Third Avenue, a fund family best known for picking stocks, launched the Third Avenue Focused Credit Fund (TFCVX), planning to keep 50 to 60 holdings across a broad spectrum of bonds. That includes so-called "distressed debt" of troubled companies, offering the prospect of big returns but also plenty of risk.

It's a small start. For example, Fairholme's new offering holds just $23 million so far, with Berkowitz personally investing $8 million of that himself. It's a pittance against the $10.6 billion in the Fairholme Fund. Third Avenue's fund has $346 million in assets— a strong start for a fund that's barely four months old, although hardly big compared with most established funds.

But the launch of two such funds in a few months is already drawing some critics.

"This is a product whose time hasn't come," says Marilyn Cohen, CEO of Envision Capital Management, which manages $253 million for individuals, all of it in fixed income.

The record has been mixed for concentrated stock funds. "When it was good, it was good, but when it was bad, it was horrid," Cohen says.

That may be OK for many stock investors who don't mind putting some of their portfolio into an unusually volatile fund. But few bond investors want it that way. They typically seek the diversification and safety of having a fund manager choose and hold hundreds of bonds.

If bond investors are willing to accept volatility in exchange for potentially bigger returns, there are plenty of what Cohen calls "rock-and-roll" bond classes: "You can go to emerging market debt, or high-yield debt."

Berkowitz figures there's plenty of opportunity for bond investors to minimize risks while earning outsized returns similar to those that Fairholme's biggest stock fund is famous for.

Fairholme's investing team already delves deeply into companies' credit risks when it picks stocks. If a stock looks like a good bet, then any bonds that company issues may also be worth picking up, he figures.

"We stay within our circle of competence," he says. "And if we believe there is a good security out there, why not buy more of it?"

Miriam Sjoblom, a Morningstar bond fund analyst, says the new offerings from Fairholme and Third Avenue will probably win over plenty of investors because both companies have strong reputations. She also notes many investors are shifting into bonds these days because they've held up better than stocks over the past decade. In fact, bond funds commanded more than 90% of the $377 billion that flowed into mutual funds last year.

And bonds, particularly high-yield bonds, look like a good income alternative to the current near-zero yields for most money-market mutual funds.

Still, investors who try the two new funds should be careful, Sjoblom says.

The risk of a single bond issue in a concentrated portfolio going sour "is the one investors needs to get comfortable with."

"If the managers make a bad call on one or two names," she says, "that could smart."

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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