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Three Funds in the Midst of Turnarounds

Poor past results don't always portend a poor future.

Human beings tend to extrapolate history into the future. If a sports team, a company, or a mutual fund has done poorly in the past, we're naturally prone to think it will do poorly going forward. Clearly, though, changes can come to pass that fundamentally change the situation. A new owner or head coach can reinvigorate a flailing sports franchise, as an executive can a firm. When an executive turns around one flailing company, as Jaime Dimon did at Bank One, investors start to believe that person can do it again--as many think Dimon will at  J.P. Morgan Chase & Co. (JPM).

For the most part, however, people rarely talk about mutual fund turnarounds. One reason is that because we're so ingrained to think that manager stability is good, we forget that keeping a mediocre or poor manager around forever is certainly not good. Also, we tend to see each fund as a ship and each manager as a skipper. And if the ship's a bad one--which we can trick ourselves into believing by looking at rotten past performance or a low Morningstar Rating--it's hard to think that a new skipper can steer it into more pleasant waters. There are also far more sensible reasons that we're skeptical of fund turnarounds. Oftentimes new managers follow the same or substantially the same strategy that has failed before. Or, similarly, the shop has its managers following such strict marching orders that it doesn't seem to matter who runs a given fund.

Still, it is certainly true that fund manager changes can work.  In a recent article, Senior Analyst Bill Rocco outlined four instances in which management changes shouldn't trouble investors:  when there is a partial manager change at a good fund, when a long-tenured analyst or assistant manager takes over as lead manager, when a talented outsider arrives, or when a solid manager inside the firm takes over a lagging fund. Today we'll use Morningstar's   Premium Fund Screener to search for funds that might be examples of these last two scenarios.

First, we'll establish our universe:  We only want to see one share class of each fund, and we'll concentrate on domestic-stock funds, although we wouldn't have to. Next, we'll look for the fund's black mark, in this case a two-star or lower rating (but we could also use long-term performance). Then we'll look for the turning point:  a manager change within the past three-and-a-half years and a 3-year return ranking in the top half of its category (the six-month difference allows for a transition period). Finally, since such a search is ideally a prelude to buying a fund, we'll demand that funds be cheap and open to new investors.  To run the screen yourself, click  here.

As of Jan. 21, 2005, 18 funds pass the screen. Before we highlight a few funds that are just what we are looking for, a disclaimer's in order. We're looking for three years of above-average performance and a manager who's been in place for three and half years at most. But as we say around the halls at Morningstar (a lot, I might add):  correlation is not causality.  That's a fancy way of saying that just because the manager's arrival and a performance turnaround coincide, one doesn't necessarily drive the other. The fund's long-lagging strategy or positioning, for instance, might have worked for a short time on the new person's watch--and it might disappoint going forward.

That said, here are three funds that we think are turnaround stories

After two nasty years under previous managers, a team from MFS led by Steve Gorham and Ed Baldini took over. They brought with them a standard, but solid, value approach: They look for firms whose valuations are below market norms but have good balance sheets and cash flows. That's not flashy, but it's clearly a more stable, sensible approach than the big sector bets that the first manager made, and more supple than the index-hugging quant strategy pursued after that.

 AXP Growth (INIDX)
The story here is quite straightforward. In early 2002, AXP wooed and won Nick Thakore away from Fidelity, where he ran  Fidelity Fund (FFIDX). Before Thakore arrived, big sector bets--which drove subpar results--were the order of the day. While Thakore also favors some areas (like health care) over others (he's been light on tech for a while), he doesn't make erratic sector shifts.  That plus a valuation-conscious strategy make this fund's behavior more moderate than most large growth funds'.

 Janus Enterprise (JAENX)
Although possibly not the worst offender, Janus was certainly one of the shops most well-known for getting caught up in the excesses of the 1990s bull market.  For instance, many of its funds bet big on technology and telecom stocks in the late 1990s--and afterward. In late 2000 this fund still had a 35% tech stake and a 20% telecom stake. Now most of Janus's portfolios are less aggressive, including this one. Jonathan Coleman runs this portfolio for the long term, both in terms of thinking and holding periods. He's also diversified the fund across sectors and holdings more than it once was. The fund has clearly calmed down, and yet is hardly tame.