Down and Out Funds Make Comeback

06/16/2009 12:00 pm EST

Focus: FUNDS

Tim Middleton, contributor to MSN Money, says some well-known funds that were doing very badly have rallied strongly this year, and he draws some lessons from it.

William Miller, who as manager of Legg Mason Value Trust (LMVTX) had beaten the market for an unprecedented 15 consecutive years, then seemed to lose his touch. In last year's first quarter, his fund suffered its worst three months ever. By the end of 2008, his investment company was laying off staff members as shareholders were leaving in droves.

This year the fund is trouncing the market, and investors who sold are losing out again.
The same thing is occurring throughout the mutual fund industry, where scores of brilliant managers are showering double-digit gains on shareholders who were willing to endure a brief but terribly painful period of underperformance. It's an important lesson in when not to sell and, looking forward, a buying opportunity, since these great funds remain relatively cheap.

Another legendary manager coming in from the woodshed, Christopher Davis of Davis Opportunity B (RPFEX), predicted this exact scenario several years ago. Every top-drawer manager, he said, is likely to underperform for three consecutive years out of any ten. No sooner did he say it than his fund took exactly such a dive, plunging to the 84th percentile of similar funds last year, only to surge to the 19th percentile this year.

The rise and fall and rise of top-tier funds is not a fluke; it is hard-wired into the investment process. So far, 709 distinct mutual fund portfolios that finished last year in the bottom 25% of similar funds have surged into the top 25% this year. That is nearly 10% of the entire mutual fund [universe].

Conventional investment wisdom holds that markets are very efficient, that investors are very well-informed and that therefore market averages—which are the sum of all investment decisions—are ultimately unbeatable.

The theory goes that market-beating fund managers will inevitably "return to the mean," or lapse into mediocrity. The conclusion, then, is that you're better off with a simple, low-overhead fund tracking an index.

But markets are anything but efficient, and investors are and always emotional, torn between fear and greed. Great investment managers tend to be independent thinkers, and they are stubborn. When markets go against them, they simply refuse to alter the investment approach that, after all, has made them great.

The reason is that markets are rationaltheir movements make senseonly over very long periods. In the short term they can be extremely irrational, and that has been particularly true over the past three years. Risk is what mutual fund managers are paid to take.

That's why you should never sell a mutual fund simply because its performance, even when compared with funds investing in similar stocks, takes a dive. In fact, expect it to underperform from time to time, especially when markets seem unusually wacky. You are apt to get your greatest profits soon after huge numbers of your fellow shareholders have bailed out.

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