How These Big Losers Could Pay Off for You

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Over the years, actively managed mutual funds haven't had the best track record against major market benchmarks. And so far this year, active funds are really stinking up the joint. But there may be a silver lining from the egregious underperformance of active funds in 2011.

Research from JPMorgan Chase shows that out of roughly 2,800 stock mutual funds, almost half have underperformed their benchmarks by more than 2.5 percentage points. That's the highest percentage of underperformers since 1998, and it compares with only 13% of funds beating their benchmarks by at least that amount. Moreover, August's swoon has only contributed to the problem, as the proportion of losers to winners almost doubled between the end of July and last week.

Staying active
As a group, active fund managers have a tough time meeting the benchmarks they pursue. One problem is obvious: Because actively managed funds have to pay the expenses of a fund manager as well as regular transaction costs and other overhead, they have a bigger hurdle to overcome just to break even. During bull markets when stocks average annual returns of 10% or more, an extra percentage point in fees may not seem like a whole lot. But when stocks struggle to break even in a given year, losing a big chunk of a minuscule return to fund fees often means the difference between beating an index and falling short of it.

Still, some active fund managers have distinguished themselves with strong track records over long periods of time. Yet even those market-beating managers have run into huge obstacles lately. Consider the following:

  • Fairholme Fund manager Bruce Berkowitz, named manager of the decade by Morningstar, has seen his fund get off to an abysmal start this year. In particular, his big bets on financial stocks Citigroup (NYSE: C  ) , Goldman Sachs (NYSE: GS  ) , and AIG (NYSE: AIG  ) have produced huge losses, pushing the fund down more than 27% so far this year.
  • Ken Heebner of CGM Focus Fund has had similar performance problems, with a 23% loss so far in 2011. For Heebner, natural resource play Alpha Natural Resources (NYSE: ANR  ) and hard-drive maker Western Digital (NYSE: WDC  ) have been a big source of the drop.

What's next?
The interesting conclusion that JPMorgan draws is that after a period of underperformance, investors can expect stocks to go up for the remainder of the year. In particular, highly volatile stocks tend to rise as desperate mutual fund managers pile into them in an attempt to get the most mileage possible from a market recovery.

You can see that phenomenon in action among some weaker performers. Berkowitz has mostly stuck with his bet on financials, but if you look at the actions that Heebner took in the second quarter, you can see some major adjustments. For instance, Heebner added Wynn Resorts (Nasdaq: WYNN  ) and Freeport-McMoRan (NYSE: FCX  ) , both of which are poised to do very well if the economy doesn't fall into a deep recession. CGM Focus has also added many stocks that have already seen big gains this year, making it apparent that Heebner wants to ride momentum to bring his fund's performance back.

What you should do
In response to bad fund performance, many fund shareholders have already headed for the exits. I'd argue that getting out now is like trying to close the barn door after the cows are already gone -- you'll only lock in the losses that you've already suffered, and while they could easily drop from here, it's more likely that you're closer to a bottom and will end up selling out at the worst possible time.

It's always hard to figure out when the right time is to give up on an actively managed mutual fund. Before you decide to bail out entirely, first come up with a reasonable replacement for that money that fits just as well in your overall asset allocation. That way, you shouldn't get hurt as much if the stock market bounces sharply from here.

Meanwhile, if you've had it with actively managed funds, you might want to give index-tracking exchange-traded funds a try. The Fool has three ETFs that should benefit from an improving economy in this free special report. Take a look today and start saving on fund fees.

Fool contributor Dan Caplinger always tries to make lemonade from lemons. You can follow him on Twitter here. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of AIG, Citigroup, JPMorgan Chase, and Western Digital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy wants you to be a big winner.

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