Why Good Funds Turn Bad

Finding great actively managed funds is a snap. Anyone with access to a computer can screen for funds that have outpaced a particular market or benchmark over just about any time period. But picking funds that will excel in the future is another story. As advocates of indexing are quick to note, few of those past winners will shine in the years to come. Some will lag their bogeys by a bit; many will metamorphose into mediocrity; and a few will turn into flat-out disasters.

Asset bloat. When funds do well, money comes rushing in, and managers have to adapt, says Morningstar’s Jeffrey Ptak. Stock fund managers, for example, must hold more cash, invest in more firms or take bigger positions in their existing holdings. If their stakes grow too big, managers, especially those of small-cap funds, risk pushing up share prices when they buy and pushing them down when they sell, which can hurt returns. All else being equal, a smaller fund is better than a big one.

Excessive risk. Funds with great records will suffer if a risky bet goes awry. Take Sequoia. The once-stalwart fund cratered after it bet 32% of its assets on Valeant Pharmaceuticals, which sank 92% amid scrutiny about the drug firm’s business practices. Outsize sector bets can also foil good funds. Fairholme Fund stumbled badly in 2011, when it had more than 70% of its assets tied up in out-of-favor financial stocks. Avoid funds that take an excessively large position in one sector or in one or two stocks.

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Manager luck. Judging how much of a fund’s performance is due to a manager’s skill and how much is due to luck is tricky. Still, a few questions can help identify managers who had more luck than skill: Was the bulk of the fund’s winning long-term record concentrated in one or two years? Did a single great stock pick or sector bet fuel the performance? Was much of the record achieved when the fund was tiny (and the manager could buy and sell securities without dramatically

impacting their prices)?

One way to scrutinize a manager’s ability to stay above the fray in bad times is to check how the fund performed in 2008 compared with its peers and an appropriate benchmark. When good funds lose, they tend to lose less than poor ones. Still, it’s best to accept bad stretches for what they are—inevitable—rather than a sign that a manager has lost his mojo.