Betting on financial stocks

(Money Magazine) -- Some of the most scorching returns these days are coming from funds that have made big wagers on the financial sector. There's Legg Mason Capital Management Opportunity (LMOPX), run by Bill Miller, with a 54% return over the past 12 months. Bruce Berkowitz's Fairholme (FAIRX) is up 36%.

Such numbers are awfully tempting -- all the more so because they aren't coming from go-go tech junkies but from "value" stock pickers who specialize in beaten-down, bargain-priced stocks, which is conventionally considered a safer approach. So should you get into one of these funds?

Take a deep breath first. Sure, value funds can be conservative. Stocks with low prices relative to earnings or financial value shouldn't have as far to fall as high-flying growth stocks, which can be hammered by disappointed investors if they earn a penny per share less than expected. But low prices don't insulate the funds from every risk.

Especially when you are talking about financial stocks -- you know, the sector that nearly brought down the economy not so long ago.

The Legg Mason fund's bet on the bankers helped deliver a 65% loss in 2008. But thanks to the bailout, the sector made a comeback, and a handful of value-driven funds are flocking there.

Besides Legg Mason and Fairholme, Ariel Appreciation (CAAPX), Clipper (CFIMX), and FAM Value (FAMVX) have 25% to 45% of their assets in the industry.

"Financials are coming out of a period of extreme pessimism," says Berkowitz of Fairholme, whose fund has attracted $1.6 billion in new dollars this year. "And at these prices, we are getting strong cash flows with great potential returns."

Berkowitz started shifting into financials late last year. (Great timing.) Today the fund is the biggest owner of AIG (AIG, Fortune 500) after the government. It also owns Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500).

But dangers still loom large. The S&P 500 Financial Stock Index has lost 8.8% over the last month.

Sure, these stocks are unlikely to get hit as hard as they did in 2008 again soon. But some of the firms are still depending on taxpayer life support, and there's huge headline risk.

Goldman Sachs (GS, Fortune 500) was recently charged by the feds with civil fraud, which the bank denies, and more firms could come under scrutiny. Regulatory pressure is ratcheting up, and the financial system remains fragile.

So before you buy a hot value fund, make certain that it really fits your taste for risk and your overall strategy. The key questions to answer:

How concentrated is the fund?

Many value funds like Fairholme and Clipper don't just bet big on a sector -- they limit their portfolios to 20 to 40 stocks. That boosts potential return but also risk.

Value funds that diversify among 100 to 200 stocks, such as Vanguard Windsor II (VWNFX) and T. Rowe Price Equity Income (PRFDX), provide less glamorous returns but tend to lose no more than the market average.

Whaddya mean "value"?

"There are big differences in what value funds call value," says Morningstar analyst Gregg Wolper. Deep value funds -- Fairholme is one -- may invest in companies at risk of failing. Others stick to businesses with healthy balance sheets.

"We won't buy companies at risk of permanent impairment," says John Fox of FAM Value. Its top financial is White Mountain Insurance (WTM), a reinsurer once held by Warren Buffett.

If you want a shot at the kind of returns a concentrated or deep-value fund can deliver, spread your risks, says Matt Dmytryszyn, analyst at Russell Investments. Make a diversified fund your core value investment, then add a small stake in a more daring one. And expect some bumps along the way.