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Lessons From Losers

The mutual fund universe runs thousands of options deep. And the marketing information out there tells you why each and every one of those mutual funds deserves your hard-earned cash.

But most of them don't.

Fortunately, we can learn important lessons by studying the industry's losers. So without further ado...

The (not-so) lonesome loser
A quick look at Federated Kaufmann (KAUAX), and you might think I'm the loser! After all, this fund has shown outstanding five-year returns, sailing past both its own mid-cap growth category and the S&P 500 index by more than five percentage points per year. Furthermore, the primary managers here have been on board since 1986. That's some solid tenure and excellent performance. So, why is this fund a loser?

For starters, that excellent performance doesn't take into account a front-end load of 5.5%, which is immediately levied against your investment. Sure enough, even when factoring in the effect of that front-end load, a sizzling fund like this can still outperform the average fund in its category. However, remember that it's hard to determine which fund is going to outperform the rest. And I, for one, would rather not start out 5.5% in the hole.

Too resilient
Now, were it just for the load, I might look the other way. But alas, I think we need to talk about resiliency. Generally, I think of resiliency as a good thing. However, this fund's management has shown a resiliency that isn't so positive. The fund's total assets under management have recently climbed to some $9 billion (pretty huge for a mid-cap fund). In the meantime, Kaufmann's expense ratio has dropped just two basis points since the fund opened -- and still clocks in at a hefty 1.93%. And that price tag includes a loathsome 12b-1 fee (a distribution fee often used to pay for advertising and other marketing expenses) of 0.2%.

Not only has Kaufmann's expense ratio remained higher than its category average, its management has stubbornly refused to close the doors. In other words, Federated is making more and more money off the fund and diluting longtime investors without giving them a price break. According to Morningstar, only two mid-cap growth funds with $9 billion in assets remain open to new investments -- and this, not surprisingly, is the more expensive of the two.

Too big
Along those lines, this fund has grown to a nearly unwieldy size. It now owns almost 300 companies, including CB Richard Ellis Group (NYSE: CBG  ) , Advance Auto Parts (NYSE: AAP  ) , PetSmart (Nasdaq: PETM  ) , Allergan (NYSE: AGN  ) , and LG Philips (NYSE: LPL  ) . The more stocks the fund holds, the closer it will move toward mimicking the benchmark it is tracking. And if you'd like to mimic the index, why not buy the index itself? Your fees would be a whole lot more palatable.

Too sketchy
Last, but definitely not least, Federated announced that it was involved in the mutual fund scandal a couple of years back. Specifically, it allowed late trading of the Kaufmann fund to a hedge fund as part of a negotiated contract. This is just the icing on the cake for a management team that already seems to be shirking its fiduciary responsibilities.

Lessons learned

  1. Beware of stubborn management. Fund companies that aren't willing to close the doors to new investments may not have fund holders' best interests in mind.
  2. Watch out for funds with expense ratios that don't decline commensurate with a growing asset base.
  3. Historical performance alone does not a great fund make.

There are always lessons to be learned from the vast universe of bad mutual funds. And from time to time, Shannon Zimmerman, lead fund analyst at the Fool, highlights a loser (or "dud," as we like to call them) in his Motley Fool Champion Funds investment service. But he doesn't stop there. In each issue, he also profiles a new recommendation (or "Champion," for those following along at home).

Sure, I can sit here all day and point out reasons why not to invest in a mutual fund. It's another thing to point out those select funds deserving of your hard-earned cash. Shannon does just that. Go ahead and see what he likes free for 30 days by clicking here. To top it all off, if you aren't completely satisfied, there's no obligation to subscribe. That said, I think you'll be pleasantly surprised.

Ryan Angell owns no shares of the companies mentioned above. PetSmart is a Stock Advisor recommendation. We tell you all this because of the Fool's disclosure policy.

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