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How to Keep Your Head When Your Fund Is Losing Its Tail

Reviewing some key items can help determine if a slumping fund has permanently lost its touch.

The crowd loves a winner and hates a loser. If a fund that has long been the former starts looking like the latter, the enmity seemingly doubles. There are obvious culprits, such as a big change in the process or the departure of key personnel, that are clear signals it is time to say "adios."

But what do you do with a fund where the only thing that's changed for the worse is its recent performance?

First, don't let emotion rule the day. (My colleague Christine Benz talks about keeping your worst instincts in check in this recent interview.) Rather, take a methodical approach that checks a variety of angles. There's no magic formula, but the broad themes below can help ensure that you use your head and not your heart when deciding whether to stay or go with a struggling fund.

Time Separates Skill From Luck
Don't fall prey to the tendency to overemphasize and project forward the recent past. A simple exercise helps. Force yourself to work backward to the present from the longest point in a fund's record. This doesn't change the individual facts at all. But it puts primary emphasis on the most important period--the long term--and forces you to reconcile it with the least important--the most recent.

That's what I did when  Oakmark Select (OAKLX) struggled in 2007. The fund lost 14% and lagged nearly all its peers by a mile. Manager Bill Nygren made a big mistake that year, keeping 14% of assets in Washington Mutual, which cratered. The year's loss made the fund's near-term record abysmal, but even at its lowest point it had still returned an average of 15% annually since its 1996 inception--double the category average. The fund's long-term success wasn't a fluke and gave me confidence that 2007's debacle--albeit painful--was an isolated event, not the first step toward perpetual mediocrity. I added to my stake, and the fund has been one of the best-performing equity funds since.

Only the Lonely
Funds that stand alone can send out the wrong signals. They often look much better or worse than they really are at any given time because their recent performance is usually zigging while others are zagging. Take  Weitz Partners Value (WPVLX). Managers Wally Weitz and Brad Hinton don't follow the crowd, and their portfolio looks nothing like their peers'. The fund has always maintained a stellar long-term record, but its calendar-year returns almost always land near its category's top or bottom--never the middle. For example, it effectively pre-crashed in 2007, as it held huge stakes in consumer-related and media stocks that headed south before others as recessionary clouds formed. The fund lost money and lagged nearly all its rivals for the year, and its midterm record sank like a stone to among the category's worst. But those same stocks roared back a little more than year later, and now the fund ranks among its group's best in all trailing periods. Reality lies between those two extremes.

Strange Times
Sometimes an anomalous time period makes a fund look worse than it is. That was the case way back in 1999 with  Clipper (CFIMX). Then-managers James Gipson and Michael Sandler ran a conservative ship and maintained a multiyear 45% cash stake in the face of racy price multiples during the Internet bubble. The fund's relative returns looked awful, and it badly lagged the S&P 500 Index. Lost in the shuffle was the fact that the fund had earned 25% annually for three years--great in anyone's book. When the bubble burst, the fund's relative rankings quickly raced to the top, even though its absolute returns shrank a ton. Perversely, this eliminated complaints about the fund's underperformance, even though its shareholders were making considerably less money than when the fund was "lagging."

Clipper is going through a somewhat similar situation under its current managers from Davis Selected Advisers. Its struggles in 2008's bear market have torpedoed its near-term record, but it still looks solid based on Davis' record over a full market cycle at its other charges. 

On the flip side is  Turner Midcap Growth . Its fairly aggressive growth strategy has always crushed the competition in buoyant markets but lagged a bit in down periods. The past decade includes two bear markets, and the S&P 500's monthly returns were in the red more than 40% of the time during the period, considerably more than its historical norm. So, the fund hasn't been in its element, and its 10-year return lags most of its rivals'. But an extended bull run in stocks would likely resurrect its standing in a hurry.

Not All Ranks Are Created Equal
The past decade has been ugly for most asset classes, with small gains or losses as the rule, rather than the exception. This means most category rankings are based on a tightly constrained range. In the large-value category, a 10-year annualized gain of 1.6% lands a fund in the group's worst third, but a 3.1% gain puts it in the top third. Neither is good on an absolute basis. It is easy to see how a good month or two is all it would take to vault a fund from the group's basement to its penthouse, and vice versa. So, it is critical to maintain a sense of scale.

Even funds whose rankings have gone off the deep end can still be within striking distance of the top. Take  Brandywine (BRWIX). It got hit hard in 2008 and then missed the mark in 2009's big rally. Its returns now land in its category's lower reaches in every trailing period going back 15 years. Brandywine lags 70% of its rivals over the past 10 years, during which time it has turned an initial $10,000 investment into $7,935. But its typical peer shouldn't be popping the Champagne: It has turned the same investment into $8,050--barely more. There are legitimate concerns about Brandywine's execution and whether its channel-check-based approach still gives it a competitive edge, but its poor relative returns should be put into perspective.

Reaching a Verdict 
It's tempting to rush to become judge, jury, and executioner with a struggling fund, but it's rarely the best course. Taking the time to dig into the facts in a dispassionate manner often reveals a different story that might give you the confidence to stay the course. And if you still decide to cut your fund loose, you can be confident you've done your homework and are doing so for the right reasons. That was the case earlier in this decade after the Internet bubble burst and fully exposed the fact that  White Oak Select Growth's (WOGSX) feast-or-famine risk/reward profile would make it very tough for the fund to deliver over time.


Michael Breen has a position in the following securities mentioned above: OAKLX. Find out about Morningstar’s editorial policies.