(MONEY Magazine) – In 1982, Sequoia Fund closed its door to new investors, becoming a kind of family heirloom to those lucky enough to be in it. With 15% long-term annualized returns and Warren Buffett's personal endorsement--not to mention a Buffett-esque style of investing--Sequoia acquired such a mystique that a gray market developed for Sequoia shares. So desperate were some outsiders to get in that they paid existing investors five times face value for a single share that conferred the right to buy more.

People don't usually quit a club this exclusive. So we were surprised to see that Sequoia's net assets, once as high as $4.3 billion, had dwindled by $700 million between March 2002 and June 2003, despite positive returns. Turns out that Sequoia managers William Ruane and Robert Goldfarb had letters sent to some 200 major shareholders, encouraging them to switch to private accounts managed by their firm, Ruane Cuniff & Co. Why? As one large shareholder explained to us, Sequoia has been bumping up against an obscure and seemingly innocuous Internal Revenue Service rule that limits mutual funds' ability to take big positions in too many stocks. In other words, Ruane Cuniff thinks it can do a better job for investors in the more flexible private accounts.

This raises some interesting questions for Sequoia's remaining shareholders as well as for investors in other concentrated funds. "Focus" or "select" funds, which hold 30 or fewer stocks, are among the fund industry's hottest products. According to Lipper, assets in such funds have grown 59% to $70 billion since 2001. Sequoia's predicament suggests that such a strategy, at least when taken to its extreme, can be hard to execute within a mutual fund.

The IRS diversification rule ensures that mutual funds are what they claim, not holding companies masquerading as funds to skirt corporate income taxes. The rule says that once positions of 5% or more of assets total over 50% of a fund's value, the fund can't add to those stakes. (It's okay if the threshold is breached as a result of price appreciation.) In other words, if a $100 million fund has $5 million each in 10 different stocks, it would be barred from purchasing additional shares of those 10 companies and also from creating any new 5% positions.

For the typical equity fund, this rule is virtually irrelevant. But it can be a headache for managers of concentrated funds. White Oak Growth Stock, Yacktman Focused and several Fidelity sector funds all face constraints on what they can buy. Oakmark Select manager Bill Nygren says there have been times when he's added to a 9% stock instead of a 4.5% one, solely because doing the latter would have created a new 5% holding and pushed him close to the 50/5 threshold. "Occasionally you get into weird positions where the trade that further concentrates the portfolio is legal, but the alternative that would help diversify it is barred," says Nygren. "It's not something that usually constrains us, though."

The same cannot be said of Sequoia. As of June, the fund had 72% of its assets in five stocks--34% in Berkshire Hathaway, 13% in Progressive, 12% in Fifth Third Bancorp, 7% in TJX and 6% in Mohawk Industries. Ruane and Goldfarb wouldn't talk for this article, but in a rare interview two years ago, Ruane told MONEY, "I firmly believe that your top six ideas will do better than your others."

Problem is, their top positions have appreciated so much that Sequoia looks stuck. "The rule limits their ability to react to changes in valuations," says Morningstar analyst Dan McNeela. They can't buy more shares of their top five stocks. They can't push smaller positions like Ethan Allen or Walgreen past 5%. And they can't easily take profits in supersize holdings like Berkshire or Progressive, since the rule could stop them from rebuilding those positions later on. It "works like a roach motel in reverse," Goldfarb complained at Sequoia's annual meeting. It's easy to check out of a 5% position, he said, but "very hard for us to check back in."

The upshot is that Sequoia now has a bigger cash position--18%--than its managers would prefer. That makes us wonder if buying Sequoia's underlying stocks is a wiser move than holding the fund itself. (It's certainly better than trolling the gray market.) With only 15 stocks and a 1% annual turnover, the fund's portfolio is easy to duplicate. And with no 50/5 rule to worry about, you might want to invest more in some stocks than Sequoia is allowed to. Which ones? Goldfarb seemed to drop a hint at the annual meeting: "The fact that we took Mohawk up to 4.99% of assets speaks volumes as to our enthusiasm about this company." --JON BIRGER