The New Mutual Fund Danger

Actively managed mutual funds are used to criticism. For decades now, investors and talking heads have bashed active funds for their high fees and lackluster performance. And these criticisms are well-deserved: Many active funds are too pricey and a majority won't be able to beat their index over the long run. But this year has seen a new and growing threat to the stability of many of these funds.

Changing of the guard
Active funds are only as good as the managers who run them, which is why it's vitally important to examine the track record of any fund's current skipper before you buy. And when a great manager leaves a great fund, guess what? Odds are good that fund won't be great for much longer since its prior track record is no longer a good indication of how you can expect it to perform in the future. Unfortunately, manager departures are on the rise, which could lead to problems for many investors.

According to Morningstar data that was collected on behalf of U.S. News & World Report, fund manager departures have been hitting record levels as of late. The Morningstar data shows that so far this year, 665 funds have implemented a change in management. If that pace continues through the end of the year, that number could reach more than 1,000. In comparison, 783 funds underwent a management change in 2012, while 747 made a switch in 2011 and just 626 did in 2010. That means there will be many more fundholders forced to reevaluate whether or not to continue owning their funds.

Given actively managed funds' generally poor performance in recent years, it's not terribly surprising that management shake-ups are on the rise. Active funds as a group greatly lagged their indexes during the most recent bear market and in its immediate aftermath. In fact, according to Morningstar, while the S&P 500 has posted an annualized 8.3% return over the past five years, the average actively managed large-cap blend fund has only measured in with a 7.2% showing. So while the games of manager musical chairs is understandable, the results aren't always beneficial for investors.

Out with the old
Perhaps one of the highest-profile examples of how a change in the helm can trigger a change in fortunes for a fund is the case of Fidelity Magellan (FMAGX). Run by superstar investor Peter Lynch back in the 1980s, the fund rose to prominence on the power of Lynch's stock picking, amassing billions of dollars in assets along the way. However, after Lynch left the fund in 1990, a series of successive managers failed to replicate his success. While the fund peaked at more than $100 billion in assets in the late 1990s, poor performance has weighed on the fund ever since. At last glance, Magellan held just more than $15 billion in net assets and lands in the bottom 5% of all large-growth funds over the past decade. The fund also lags the SPDR S&P 500 ETF (NYSEMKT: SPY  ) by 2.6 percentage points a year in that time frame.

Of course, manager changes can also be beneficial for funds. For example, Fidelity Large Cap Stock (FLCSX) was a floundering, undifferentiated offering before manager Matthew Fruhan took over in 2005. In the decade before Fruhan came on board, the fund lagged the S&P 500 Index by more than 2 percentage points a year, gaining 7.5% on an annualized basis compared to 9.8% for the S&P. However, Fruhan proved to be an able skipper and the fund's performance has improved markedly under his guidance. More recently, he has helped boost returns with a hefty dose of financial stocks such as JPMorgan Chase (NYSE: JPM  ) , Wells Fargo (NYSE: WFC  ) , and Citigroup (NYSE: C  ) , all of which made their way into the portfolio because Fruhan felt they had the ability to meet the requirements of a stricter regulatory banking environment while still being able to grow earnings. Since the start of his tenure, Fidelity Large Cap Stock is up 8.8% annualized versus 6.9% for the S&P 500.

And in with the new
So does a manager departure mean it's time to bid adieu to your mutual fund? In many cases, yes. If the new incoming manager doesn't have a verifiable track record running money in the same style and with the same objective as the current fund, you should think twice about staying put. There is certainly the chance that the new manager could exceed expectations, but without a proven track record, there's not much for fundholders to hang their hats on. You should demand to see proof of success before you commit your money.

However, not all manager switch-ups mean that you need to hit the sell button. If your fund is run by a team of portfolio managers, one person leaving that team is unlikely to result in meaningful changes to the fund's investment process. Firms like Dodge & Cox utilize a multimanager structure so that any one person's departure won't affect the fund. Likewise, if the new manager or management team has an extended history of investing similarly and has a prior track record of success in multiple market conditions, you can probably rest assured that they will continue to shine at their new charge.

Manager changes are always a catalyst to review your reasons for owning a mutual fund, so keep up to date on who is running the show at your funds and don't be afraid to cut your investments loose if need be. 

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