An Investor's Guide to CGM Focus

The coronation of King Ken is under way. Before the old year had even ended, Investor's Business Daily published an article about the over-the-top returns in 2007 of Ken Heebner's CGM Focus fund.

Over the next few days, you'll see plenty more in the business and general press about Focus, which returned 80% in '07, beating Standard & Poor's 500-stock index by a tidy 74 percentage points. Only two specialized funds, both leveraged, did better last year.

Make no mistake: Heebner is a marvelous investor. CGM Focus (symbol CGMFX) has been a member of the Kiplinger 25, the list of our favorite no-load mutual funds, since May 2006, and Heebner adorns the cover of the January 2008 issue of Kiplinger's Personal Finance magazine.

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My concern, however, is that many investors will see that 80% figure and jump into Focus without fully appreciating the fund's extraordinary volatility and risks. This won't be a surprise.

Performance-chasing investors often buy first and ask questions later, usually after one year's sizzler turns into next year's black hole. They typically forget one of the basic rules of investing: High returns are usually accompanied by high risks.

By highlighting Focus's risks, we don't mean to suggest that either the fund or Heebner are flashes in the pan. Focus's long-term record is fabulous, too.

The rewards. Over the past ten years through 2007, according to Morningstar, the fund returned 26% annualized. That beat the S&P 500 by an average of 20 percentage points per year. An investor who placed $10,000 in Focus ten years ago would now have a stake worth nearly $102,000.

More to the point, Heebner is one of the smartest, most-intuitive money managers around. I first spoke with him 21 years ago, shortly after joining Kiplinger's. At that point, Heebner already had an 11-year record on CGM Capital Development, a fund that has been closed to new investors for years.

It would be easy to accuse us of Heebner-worship. One reason we are so enamored of him is that he operates so differently from most fund managers.

He trades frenetically. He makes huge bets -- Focus owns only about 20 stocks. He doesn't care where a company is based, which makes Focus, with 63% of assets in foreign stocks at last report, look a lot more like a global fund than a domestic fund.

And he's willing to bet against stocks by selling them short. Focus, in other words, is run like a hedge fund in the guise of a mutual fund.

And most of Heebner's bets begin with his big-picture view of the economy, the markets and individual sectors. Most other managers say they pay little heed to such top-down analysis and instead pick stocks from the bottom up -- that is, issue by issue.

It's this big-picture thinking that prompted Heebner to invest in fertilizer stocks Mosaic (MOS) and Potash Corp. of Saskatchewan (POT). He sees growing wealth among developing nations translating into higher living standards for their citizens. That means more demand for meat and grains, which leads to more demand for fertilizer. Heebner also sees growing demand for corn-based ethanol boosting fertilizer prices.

At any rate, the next time you feel like crowing about your killing in Apple (AAPL) or Google (GOOG), just remember that shares of Potash tripled in '07 and that Mosaic's stock more than quadrupled -- up 341%, to be precise.

The down side. But now let's turn to the risks of CGM Focus. Bear with me as we spend a little time looking at some numbers.

Many of Heebner's techniques -- particularly concentration, rapid trading and short selling -- make Focus extra volatile. How volatile?

Statistics geeks like to look at standard deviation, which in this case measures how much a fund's returns vary from month to month. Over the past three years, Focus's standard deviation has been nearly three times greater than that of the S&P 500 index.

Put aside the gobbledygook and look at actual returns. Consider, for starters, monthly results. Since Focus's launch in September 1997, it has surrendered 10% or more in a month on eight occasions.

The S&P index has experienced two monthly double-digit declines -- 11% in September 2002 and 15% in August 1998. Focus has had four monthly losses of 20% or more -- 20% each in August 1998, September 2001 and July 2002 and a breathtaking 24% drop in January 2001.

And when Heebner's thinking is out of sync with the market, Focus can lag by wide margins over lengthy periods. Consider that from the fund's launch through January 2000, Focus lost 7% annualized (or a cumulative 15%). Over the same period, the S&P 500 gained 19% annualized (or 51% cumulative).

If you think I'm trying to frighten you, you're right. Anyone who puts money in this fund should be aware how quickly you can lose big chunks of your investment.

If you put short-term savings or a disproportionate amount of your wealth into Focus, you are courting trouble. And if you buy into the fund thinking that you truly are a long-term investor who can ride out those short-term spills, you'd better be right.

CGM Focus should be a relatively small part of a well-rounded portfolio, probably 10% to 15% of your assets at most. Focus is ideal for dollar-cost averaging -- investing a fixed amount at regular intervals -- because that technique puts you on automatic pilot and takes the emotion out of your buy decision.

It's okay to invest in high-risk funds as long as their returns are commensurate with the chances they take. CGM Focus is such a fund. But it also represents a classic case of look before you leap.