When to dump a loser mutual fund

Funds in the bottom of the quarterly rankings share some attributes that investors can watch out for.

  • By Suzanne McGee,
  • The Wall Street Journal
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What about the losers?

Every quarter, this report looks at the funds that excel—the top-performing actively managed U.S. stock funds over the previous 12 months. Focusing on which funds end up on top tells us something about what kind of investment styles and strategies work in the current market environment.

Well, this article is dedicated to the laggards, the funds that lose money for their investors. Just as with the winners, there’s plenty to glean from looking at the funds at the bottom of the rankings each quarter. Looking carefully at the losers shows what traits troubled funds have in common—such as a manager who suddenly changes philosophy or holds stocks that don’t mesh well with the goals of the fund.

Whatever insights the losers offer, however, it’s crucial not to take away the wrong lessons. Specifically: Investors should avoid automatically throwing out each year’s poor performers with the trash, just as they should avoid automatically buying each year’s winners.

Look deeper

“One year of poor returns does not make a firm a constant underperformer,” says Lee Beck, a managing partner at Kudu Investment Management in New York. His firm provides investment capital to asset-management companies in exchange for minority stakes, so he has learned to spot the signs of trouble within mutual funds, and he says short-term losses don’t usually cause him much anxiety. “More than three years of consistent underperformance tells me that there may be some problems within the business.”

Doing a careful analysis of losers, though, can be complex. It is tough to point to a single factor being responsible for a fund’s underperformance, says Amanda Walters, senior manager at Casey Quirk, a division of Deloitte Touche Tohmatsu Ltd. that advises investment-management businesses. That, she adds, makes it tough for investors to determine whether it is time to sell, or if it is worth hanging on.

Even more problematic, Ms. Walters says, is that “it’s common for a very strong fund to underperform its benchmark and its peers, for quarters or even years.” Sometimes, a fund that will prove rewarding over the long haul—a decade or two—will even lag behind over a full economic cycle, simply because of something that is happening in the market.

The question investors therefore need to ask themselves is this: “Is a fund inherently bad, or is it bad because the market did something to it that hurt its returns?” says Greg Hahn, president and chief investment officer of Winthrop Capital Management, who oversaw investment portfolios in his former roles as chief investment officer of Oppenheimer Capital Management and Conseco Capital Management, and who now manages money for individual investors.

There isn’t a simple formula to answer that question. But there are some elements investors can watch out for.

Does the fund have a good process in place? It’s important to make sure that funds are executing their investment philosophy properly. One of the biggest red flags: Their holdings aren’t a good fit with their mission.

For instance, a fund manager says that he or she focuses on health-care companies that will benefit from new treatments for diabetes or cancer. Does the list of the companies in the portfolio seem to mirror that focus, and what percentage of the holdings are on target? If a significant percentage don’t seem to be that specific, or are just large-cap pharmaceutical companies, it could be a signal that the process is flawed.

Is the manager sticking to his or her own guns? Ms. Walters says that most managers are wary of changing their philosophy, since it is part of their brand. “It’s a tough value proposition to say, ‘We used to believe this and now we believe that.’ ”

So, it may be a warning sign if a manager makes a big change in approach. For instance, if a fund used to hold a large number of positions but now is betting on only 50 or so holdings, it has become much more concentrated, and its fundamental nature has altered.

Is there a new manager, and do I trust him or her? If the fund’s performance suddenly nose-dives and there is a new manager at the helm, that may be a reason to intensify vigilance. But investors should bear in mind: It can take three to five years, or even longer, for a new manager’s set of investment ideas to pay off in returns.

Is this negative performance coming in a segment of the market in which it is tough to beat index funds? “People don’t like talking about this, but in the large-cap growth world, it is becoming much more difficult to find inefficiencies in the market that create great investment opportunities,” says Mr. Beck. “It’s a very competitive landscape.”

Mr. Hahn agrees. “Everyone is fishing in the same pond, and it’s hard to differentiate yourself.” If you’ve got a consistent laggard in this arena—a fund that underperforms in a variety of market environments—you really need to ask why you still own it.

Are the losses due to a manager taking reasonable risks? Many big funds these days are wary of straying too far from the returns of benchmark indexes, experts say. So, they tend to do “closet indexing”—making sure the composition of their funds roughly matches that of measures like the S&P 500 (.SPX). Meanwhile, smaller funds looking to make a name for themselves are more willing to take risks for the chance of big returns, experts say.

Sure, it’s great to stand out for being able to produce above-average absolute returns, but deviating too far from the index also increases the risk of lagging behind peers in the shorter term, something big institutions seek to avoid.

So, if your fund is performing badly, ask yourself if the fund manager is losing money by making reasonable bets. The declines you’re experiencing now may be offset by periods of stellar performance down the road large enough to wipe out today’s short-term losses.

Is there a downward spiral happening? Finally, there are times when a fund is completely out of control and may be headed for collapse. One warning sign: shrinking assets. Investors will often give a fund leeway for losses, perhaps even for several years, but eventually, they will toss up their hands and abandon the fund. If they start to do it en masse, or if a big institution yanks a sizable chunk of assets, that’s a warning sign about the future of the fund, particularly if it’s a small fund that is losing a big chunk of its money.

A downward spiral also shows up in a fund’s team. The longer a losing streak extends, the more problems the fund may have keeping people, as well as recruiting successors for a fund manager who may be ready to retire. So, keep an eye on a fund’s roster of analysts and see if there’s a lot of turnover during a long stretch of bad performance.

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