Most financial experts agree that diversifying is a smart investment strategy, which is why mutual funds have gained popularity among investors through the years. Because mutual funds typically invest in anywhere from 50 to several hundred different securities, buying shares of a mutual fund is a quick way to diversify without having to go through the process of choosing individual stocks and bonds.
However, not all mutual funds hold such a diverse mix of investments. Some instead limit the scope of their investments, focusing on a particular industry or selection of companies. These mutual funds, known as focused funds, typically hold positions in 20 to 30 securities or even less.
Homing in on a select few investments
Focused funds keep their holdings to a minimum and typically limit their investments to a specific sector or a set number of sectors. The securities that focused funds buy are usually thoroughly researched.
Benefits of investing in focused funds
Because they can only invest in so many stocks, focused funds are extremely methodical and strive to choose the best possible investments, which can work in investors' favor. Focused-fund managers are experts on the sectors they invest in, and some of them have a history of picking winners and beating the returns of the broader stock market.
Drawbacks of investing in focused funds
Although a focused fund's narrow range of investments can sometimes deliver market-beating returns, that lack of diversification can also leave the fund exposed to a great amount of risk. If a focused fund invests exclusively in pharmaceutical companies, for example, then the value of its portfolio could plummet if a few of its holdings experience major regulatory setbacks.
A diversified portfolio will not be sunk if a couple of holdings go south, because it will contain complementary holdings that offset those losses. Focused-funds don't have those sorts of hedges in place, so they're much more volatile. On top of that, some focused-fund managers take the idea of concentration to the extreme, which compounds the risk and volatility.
Although a mutual fund's diversification (or lack thereof) is an important consideration, keep in mind that other factors can play an equally large role. Management savvy and fees, for example, are also major factors in a fund's overall performance. If you're not sure whether to invest in a focused fund or a more traditional mutual fund, look at the big picture and see which choice could help you achieve your growth and asset allocation goals. Also keep in mind that there may be room for both types of funds in your portfolio.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!