Index funds have a place in a portfolio, providing a core position at a rock-bottom cost. But providing true diversification and extra returns requires straying well away from that benchmark.
The above quote was in the context of interviewing David Winter of the Wintergreen Fund. He used to work at the Mutual Series of funds, and has had his own shop for a while. He is on the Connie Mack show on PBS every so often.
If you are managing your own portfolio you may not be inclined to own and follow 45 stocks. I do think that a lot do-it-yourselfers can index a big chunk of their portfolio and then follow ten or maybe a dozen narrower holdings that can, depending on the investor's leanings, increase or decrease volatility or provide exposure to some themes not captured through indexing.
Exposure to single countries is one that is tough to capture through "normal," indexing but can be a way to get some genuine zig-zag compared to domestic holding. I've written more than a few times about water and oil-sands as themes that are important to me, chances are there are other non-single-country themes that are important to you. A theme like this, assuming it is one you believe in, has the chance a lot of growth that could come regardless of what the market is doing.
ETFs, where they exist, allow investors to simply learn the fundamentals of the theme, whereas picking an individual stock requires knowing the theme and the stock. This is absolutely doable, but it is obviously at least twice the work. I would say first to focus on the theme and then figure out the best way to invest in it. There may not be a fund or other product; a common stock may be the only way to go.
It is not vital that you own the single-best-performing thing to capture the effect. For example, I don't think there is an ethanol fund, but the pure play stocks (just picking a fad here that I have no exposure to) are very volatile. The theme might be right for you but the stocks may be a little too hot to handle for some folks. If there were an ETF it would capture most of the effect, with probably less white knuckle.
The theme is more important than the pick, so says top down theory.