When looking at a mutual fund with a good long-term record but lackluster recent performance, the first question to ask is “has anything changed?” The answer often rests on one of four characteristics: management, objective, size and external factors.
An actively managed mutual fund’s performance is often tied to the talent of its managers. Any time a successful fund manager departs, future performance needs to be scrutinized more closely. Some funds enjoy a successful transition and others do not.
A change in a fund’s objective can give a manager more flexibility for picking investments, but it can result in different return characteristics. Investors need to read their fund’s prospectus annually to check for any changes.
Size can create headaches for a fund following a specific strategy. This occurs when assets under management (AUM) exceed the amount a manager can effectively deploy. It can be a problem for funds that target certain foreign markets, specific industry groups or smaller companies with less trading volume. It also has the potential to be a problem for funds like Fairholme that hold a limited number of stocks (FAIRX holds just 20 stocks and seven bonds), but you need consider the average volume of each holding (aka liquidity) before viewing a concentrated portfolio as a red flag.
External factors are market and economic changes that work against a fund manager. Several gold funds, including U.S. Global Investors World Precious Minerals and Midas , posted double-digit percentage declines last quarter because mining stocks fell in value. It does not matter how good a manager is; if the category he invests in performs poorly, his fund’s returns will suffer.
The most important factor is to think about why you bought the mutual fund in the first place. Most mutual funds, including Fairholme, are intended to be held for the long term. There are some that are intended for tactical, short-term speculation, such as Direxion Monthly Dollar Bull 2x Investor and Rydex Investor S&P 500 2x Strategy. The two types of funds should not be confused. If you own a fund that follows a long-term strategy and nothing significant has changed (e.g., objective, management, size, etc.), you should not be worried by a short period of poor performance if the fund has a lengthy record of good returns. On the other hand, if you are buying a fund for purely short-term trading, be prepared to sell it quickly and do not treat it as a long-term position. Countless investors have hurt their portfolio’s performance by entangling short-term speculation with long-term investing.
This Week’s Gratis Tip
As important as performance statistics are, you will need to look beyond the numbers to determine whether a particular mutual fund is a good investment for the future. Beyond the Numbers: Getting to Know a Managerlists 10 questions you should ask when evaluating a fund.
The Week Ahead
Nearly 100 members of the S&P 500 will release second-quarter earnings next week. Dow components Bank of America, Coca-Cola and Johnson & Johnson will report on Tuesday. American Express, Intel, and United Technologies will report Wednesday. The Travelers Companies will report on Thursday, and Caterpillar, General Electric and Verizon will report on Friday.