When it comes to picking stocks, sometimes it's easy to know when you need to sell. If a company fails to capitalize on a product initiative or doesn't successfully execute its strategy, sending the stock price down, that's a signal that management may not be up to the task. But when a mutual fund underperforms, it can be a lot harder to know whether it's time to move on or to stick with it. To get a better idea of when to cut your losses with underperforming funds, let's look at four former high-flyers that have fallen on hard times.
Down for the count
Four of the largest big-name disappointments this year have been Bill Gross' Pimco Total Return (PTTAX), Bruce Berkowitz's Fairholme (FAIRX), Ken Heebner's CGM Focus (CGMFX), and Bill Miller's Legg Mason Value Trust (LMVTX). But just as investors need to examine their investments on an individual basis to determine their relative merits, so, too, should you look at each underperforming fund on its own to see whether the lagging performance is a bump in the road or whether there are bigger issues at play that warrant a potential sale. And even if a fund's manager is a talented stock-picker over the long run, does that mean his or her fund is a good buy for investors?
Taking a breather
Bill Gross is perhaps the biggest bond superstar in the business. His flagship Pimco Total Return Fund outranks 95% of its peers over the past 15 years and is now the single largest mutual fund in existence. However, Gross made a misstep earlier this year by dumping Treasuries in expectation of a pick-up in inflation. So far, inflation has remained elusive, and Treasuries staged a strong rally, causing the fund to drop behind 90% of its competition so far this year. Year-to-date, the fund has posted a respectable 3.5% gain, but that lags the 6.7% return of the Barclays Capital Aggregate Bond Index and the 5.2% return of the average intermediate-term bond fund.
But although investors may be disappointed, I don't see how you can fault Gross too much for this miscalculation. There are a lot of other gurus out there who also thought inflation would be more of an issue than it has been. And even though Treasuries have rallied recently, it's hard to argue that they're not terribly overpriced in the grand scheme of things. Over the years, Gross has a steady track record of making the right macroeconomic calls, and his maneuvering helped the fund avoid the worst of the subprime crisis a few years back. Even the best managers stumble now and then, and Gross is no exception. Stick with this fund -- Gross is still one of the best bond managers around. As such, Pimco Total Return is a good choice for diversified bond exposure for any investor, as long as you can avoid the front-end load that the fund charges.
How the mighty fall
Likewise, Bruce Berkowtiz's Fairholme Fund still ranks in the top 1% of its peer group over the past decade, and thanks to its stellar track record in recent years, it has pulled in hundreds of millions of dollars. But so far this year, things look pretty bleak. Last year, Berkowitz loaded up on beaten-down financial stocks such as AIG (NYSE: AIG ) , Morgan Stanley (NYSE: MS ) , and Goldman Sachs (NYSE: GS ) , expecting a rebound in the sector as the economy slowly improved. However, the financial sector has tumbled even further this year as economic growth has stalled. Citigroup (NYSE: C ) is down nearly 40% this year alone. As financials have struggled in 2011, the fund, with its 75% financial stake, has fallen to the bottom 1% of all large-cap value funds over the past year. Investors have responded by yanking tens of millions of dollars from the fund's coffers.
But folks who think Berkowitz has lost his touch are a bit premature. Fairholme had done so well for so long that it was inevitable that it would fumble a pass sooner or later. Just like Gross, Berkowitz is a fine money manager with a long, solid history of making excellent investment decisions. The hard part about investing in actively managed funds is having the guts to stick with your fund when it underperforms, and every single one will at some point. The fund's financial bet may not play out and investors may end up taking a loss in the short term, but the fund's long-term appeal is clear. If you're not comfortable with a fund that can take such large sector bets, you might want to bypass Fairholme, but for patient, long-term investors who can wait out the ups and downs, Berkowitz's stock calls should prove to be profitable.
Be sure to tune in later this week for a look at the recent troubles at CGM Focus and Legg Mason Value Trust and see whether investors should consider selling these fallen heroes.