How to spot a losing mutual fund

By: Leo Almazora

For many investors, building their nest egg means following to a buy-and-hold strategy to capture long-term positive returns. An important piece of that approach is choosing winning funds to include in one’s investment portfolio. Another important consideration: determining which funds to throw out.

“One year of poor returns does not make a firm a constant underperformer,” Lee Beck, a managing partner at Kudu Investment Management, told the Wall Street Journal. While he pays no mind to short-term losses, he has learned to watch out for potential warning signs, like more than three years of consistent underperformance.

When a mutual fund goes through an extended period of poor returns, it’s time to start troubleshooting. One good place to start, according to the Journal, is to see how it executes its investment philosophy. If the holdings don’t fit its stated mission well — for example, if a health-care fund that focuses on new treatments for diabetes or cancer invests significantly in large-cap pharmaceutical firms — it could be a sign of a flawed process.

Another warning sign, said Casey Quirk Senior Manager Amanda Walters, is when a manager drastically changes their approach. “It’s a tough value proposition to say, ‘We used to believe this and now we believe that,’” she said. Since the investment philosophy is part of most managers’ brand, altering it would likely be done as a desperate measure in desperate times.

A nosedive in performance may also come when there’s a new manager piloting the fund. But investors should note that even if their new ideas are solid, it can take three to five years for them to see a payoff in returns. If this is the only discernible factor for a fund’s poor showing, any decision to eat the costs of poor performance or to cut and run will depend more heavily on the individual investor’s ability to tolerate losses.

While many major funds do not want to stray too far from the returns of their benchmarks — a mindset that could lead to a greater risk of “closet indexing” — smaller funds with less to lose are more willing to take risks for big returns. The difficulty, however, is that those risks could cause the fund to lag behind its peers too much in the short term. So in a similar way, investors in small funds that experience short-term losses must ask themselves if the manager is losing money on reasonable bets, and if they are willing to wait for potentially stellar performance to erase today’s short-term losses.

Underperformance may also be due to factors outside the manager’s control: market forces may keep even strong funds below its benchmark and its peers, according to Walters. That may be due to broad economic trends, or it could be a peculiarity unique to a specific market segment. A case in point is large-cap growth, which investment professionals agree has become a very competitive category in which opportunities from inefficiencies are hard to find.

Finally, there comes a point when a fund is on the path to inevitable collapse. After forgiving a fund’s losses for several years, investors may lose faith and decide to abandon ship. A significant shrinkage of assets, either due to a mass exodus or one major institution pulling out, is something investors should watch for, especially when the fund in question is a small one.

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