Posted on: Thursday, June 5, 2003

Know when to dump fund manager for poor performance

By John Waggoner
USA Today

You have probably seen this happen all too often. You have a good friend. Nicest person in the world. And then your friend makes a horrible discovery: She has a bad mutual fund.

Why do bad funds happen to good people? We may never know. We can only try to figure out why a fund goes bad, and what we can do about it.

Finding the worst of the worst funds is easy. The three worst funds the past decade:

• Frontier Equity turned $10,000 into $400, a 96 percent loss. The fund wins a prize for chutzpah, too: It charges up to 8 percent to buy shares.

• American Heritage, down 94 percent.

• Apex Mid-Cap Growth, down 78 percent.

By way of comparison, $10,000 invested in the Standard & Poor's 500-stock index became $24,900 during the same period, a 149 percent gain.

These funds didn't start as losers, because investors typically don't buy losing funds. The perennially dreadful Ameritor fund, down 74 percent since April 1993, once had $200 million in assets and a decent reputation.

While bad funds can be tiny, their awful performance is widely trumpeted in the financial press. There are many less famous awful funds out there, and some of them have substantial assets.

Consider the Waddell & Reed Science & Technology fund, which has fallen 26 percent the past three years. No one likes a loss of that magnitude. But for a tech fund, Waddell & Reed is hot. The average tech fund has fallen 66 percent during the same period.

To make a fair comparison, you have to check your fund's performance against funds with similar investment objectives. For example, Morgan Stanley S&P 500 fund is down 17 percent the past five years — certainly not as bad as the 58 percent loss posted by PBHG Emerging Growth, the most awful small-cap growth fund. But the Morgan Stanley fund's performance stinks compared with the S&P 500, down 10 percent.

What makes a fund go bad? You have plenty of potential culprits, but the biggest ones are:

• Lousy management. Mutual Funds Magazine, now defunct, once gave out Steadman Awards to the worst fund managers in honor of Charles Steadman, the late manager of the Ameritor funds. He drove the fund into the ground when he took over in the 1960s.

• Huge outflows. As investors flee, fund managers have to sell stocks to meet redemptions. Sometimes, this leaves the fund with the stocks that are the toughest to sell.

• High fees. The Morgan Stanley S&P 500 B fund simply tracks the S&P 500, so its raw returns should be no different than any other S&P 500 index fund. What's different? The fund charges 1.5 percent annually in expenses, and that's what has weighed it down.

What should you do if your good fund suddenly starts to go bad? Be patient — but not too patient. Most fund companies fire their worst managers, and you should, too. Give a manager one subpar year. If the fund continues to perform badly, or if its three-year record falls below average, ditch it for a better fund. In general, funds with poor long-term past performance tend to have rotten future performance.