A mutual fund portfolio of just 20 stocks might seem too risky. It's certainly not a strategy that's followed by many funds. Of the 2,679 U.S. equity products listed in Informa Financial's PSN investment manager database at the end of the third quarter, only 150 - fewer than 6% - maintained a portfolio of 20 or fewer holdings. A scan of large-cap growth funds in the database shows just 2.5% of these funds hold 20 or fewer stocks. Not a very popular strategy. But it can work.

According to David Rolfe, chief investment officer of Wedgewood Partners in St. Louis, Wedgewood's focused and small portfolio SMAs have outperformed the S&P 500 fourteen out of roughly 20 years, in both up and down markets. Wedgewood's strategy is now available in the $75 million RiverPark/Wedgewood Institutional Fund (RWGIX), launched in September 2010. The firm has $1.2 billion in assets under management.

Wedgewood concentrates its portfolios in about 20 highly profitable companies in just a handful of industries, Rolfe says. The less-is-more approach involves highly focused research aimed at reducing company-specific risk through in-depth knowledge of the limited set of investments.

The buy-and-hold strategy limits turnover of the portfolio, which has averaged between 20% and 25% since the strategy's launch in 1992, according to Rolfe. "If we expect to invest in companies for many years, we must then focus on companies with the brightest multi-year prospects for growth," he says. Also, he adds, "We do not view risk via individual security price volatility. Rather, most of our risk analysis is centered on the underlying business."

Some of the advantages of this type of strategy include uncrowded portfolios and less short-term performance fine-tuning (which, according to Rolfe, leads to lower trading expenses and less inefficiency in terms of capital gains taxation).

Rolfe says he prefers to view risk not through the lens of the common measure of standard deviation of returns or other volatility type measures. If risk is defined instead as the probability of permanent loss of capital, rather than standard deviation from a mean, then "sheer volume of holdings, typically employed as a tool to mitigate price volatility, quickly loses relevance," he notes. In the small portfolio approach, "containing risk becomes an all-important qualitative exercise of intimately understanding and valuing only a few handfuls of exceptional businesses."

There are risks to overdiversifying, too, Rolfe says. Funds that are aimed at lowering volatility and price risk by having a large number of stocks can also be diluting good investment ideas, he explains.