Big Bet Investing

By Daniel Kadlec

Study after study shows that investors get all the diversification they need by owning as few as 10 stocks spread among several industries. Why, then, does the average stock mutual fund hold 134 companies? It's as confounding as the frenetic trading that goes on in many funds--even though the very fund managers triggering the trades preach patience to their investors. Lay the blame on pressure for short-term results, if you like. But these paradoxes seem idiotic to me and probably help explain why most funds fail to keep pace with the market. They don't practice selectivity and patience.

For that, many funds have paid a price. Weary of laggard returns, investors have been shifting billions of dollars to passive funds like the Vanguard Index 500, where they are assured of getting market-matching results (and lower fees). Now active managers are striking back, brandishing what I'll call the "big-bet" fund. By limiting the number of stocks in tow and generally holding on longer, these funds correct some of the faults that have driven money to the indexers.

Big-bet funds are nothing new. But they are getting a lot of attention now. A choppy market like the one we've had this summer is where savvy stock pickers are supposed to excel. There are about 150 big-bet funds, reports fund-research firm Morningstar Inc. That's up from about 100 six years ago. The theory is solid. In any large portfolio, the manager is sure to have favorite stocks--often those on which he has done the best research. Why not double up on those and ditch the rest?

For that to work, though, you need a home-run-hitting stock picker--and that creature is as rare as the Mark McGwires of the world. The Sequoia Fund, for example, has beaten both the average stock fund and the S&P 500 for the past one, three and five years. But it does not accept new investors. Some solid big-bet funds that do welcome new money include Davis Growth, Clipper, Janus Twenty, Lexington Corporate Leaders, Yacktman and Enterprise Growth.

Like actively managed funds with larger portfolios, however, only a few of the big bets beat the market. At my request, Morningstar screened for stock funds that hold 35 or fewer stocks today and also met that test in 1995 and 1993. That weeds out new funds and those that were concentrated for only a short time. The screen turned up 31 funds. Only four (Sequoia, New England Growth, Enterprise Growth and Clipper) are beating the market this year. On average, the group of 31 has returned just 12% a year for the past five years, vs. 18.3% for the S&P 500. The big-bet funds lag badly over three- and one-year periods too, though they stack up O.K. against the lower standard set by the average diversified stock fund.

Meanwhile, index funds--the bane of active managers--continue to dazzle. Their weak spot was supposed to be a down market. But when the market tumbled in August, the index funds held up better than most. Which tells you that if you can hitch your wagon to a star, big-bet funds are worth it. Failing that, though, better just to stick your money in an index fund and let it ride.

See time.com/personal for more on big-bet funds. E-mail Dan at kadlec@time.com See him Tuesday on CNNfn at 12:40 p.m. E.T.