It's scary how easy it is for investors to park hard-earned money in mutual fund stinkers. Sometimes we have limited options in our 401(k) plans and place too much trust in our administrators. Other times we just don't do enough due diligence on the front end.

Here are two ways to prevent duds from sneaking into your portfolio:

  1. Pay close attention to historical returns measured against the appropriate index. (If it's a small-cap fund, make sure results are compared with the S&P Small Cap 600 or the Russell 2000, not the S&P 500.)
  2. Limit fees paid to managers. (Ironically, many of the worst-performing funds are among the most expensive to own.)

Like our own Shannon Zimmerman, Roy Weitz at offers a lot of good writing and thinking on funds. In his September commentary, Weitz explained his "3-ALARM" rating for funds, tagging that label on a fund if it has "underperformed its benchmark over the past 12 months, three years, and five years."

Sad insights
As I scanned through a list of 3-Alarm funds, I was struck by the names of the offending funds. I had expected more offensive names. Perhaps:

  • Pigeon Capital Value Implosion Fund (Ticker: PLOPPX)
  • International Plunger Opportunity Fund (Ticker: WHOOSHX)
  • Warren G. Harding Teal Chip Growth Fund (Ticker: YIKESX)
  • Aubergine Standard Allocation Fund (Ticker: ICKICKICKX)
  • American Fidelity Balanced Compost Fund (Ticker: AUGHHHX)

But no. Instead I saw such seemingly respectable names as:

  • Eaton Vance Tax-Managed Small Growth
  • Strategic Partners Small Cap Growth Opportunity M
  • Shepherd Large Cap Growth
  • MainStay Small Cap Growth B
  • John Hancock Small Cap Growth A
  • Frontier Equity

This made me imagine how easy it would be for naive investors to park their hard-earned money in such funds, if they weren't savvy enough to do some due diligence first.

Though some of the listed funds only underperformed their indexes by a few percentage points per year, some did so by double digits in several years. In other words, they're real stinkers.

For example, according to data, the Frontier Equity fund lost 28.5% in 1998, 51.5% in 2000, 29.8% in 2001, 54% in 2002, 44.2% in 2003 ... (Is there anything left for these poor shareholders to lose?) ... 6.9% in 2004, and 20.4% through August 2005. (Apparently, yes. But to be fair, the fund did have a terrific 1999, posting a rare gain of a whopping 48.9%. Volatility, thy name is Frontier Equity!) Making matters worse, the fund charges a 4.5% load -- and the listed expense ratio is 10.47%. This seemed too bad to be true, so I did a little more digging, and though I couldn't find the company's website, I did discover that the manager is someone that our own Bill Mann has little respect for.

The fund's performance made me wonder just what it would invest in. Apparently, a top holding has been eGene (OTC BB: EGEI), which is a penny stock valued around $0.30 per share last time I checked. Not all holdings were pennies. I also spied VentivHealth (NASDAQ:VTIV) and ... well, let's just say that a bunch of them were penny stocks, known for being volatile and extra-risky. The only company I recognized from the top 25 holdings was Jones Soda (OTC BB: JDSA).

Interestingly, of the few 3-Alarm funds I listed above, most sported sales loads of around 5% to 6%. I suppose if they're not making enough from management fees taken as a percentage of (shrinking) assets, there's always a sales load to help bring in dollars.

How do they promote themselves?
Spending this time in 3-Alarm-land also got me wondering: If these funds are such poor performers, how do they market themselves? What can they boast about? I decided to do a little more digging. For some of the funds, I couldn't find much material at all. I did find information on the MainStay Small Cap Growth fund, at the New York Life website:

"Fund Objective: To seek long-term capital appreciation by investing primarily in securities of small-cap companies." (I guess it's still seeking ...) "Investment Strategy: . Strict sell disciplines seek to limit the Fund's exposure to securities with deteriorating fundamentals." That last line had me chuckling a bit, as there are two (opposite) ways to read and interpret it.

For the Shepherd fund, I did find a company website, which explained that the fund reflects conservative social and religious values, unlike many other funds. I'll admit, this could be an effective angle for attracting new investors. The fund family screens out "companies involved in abortion, pornography, gambling, tobacco, and alcohol industries, and companies that promote a same-sex lifestyle, corporate activities that many socially conservative investors do not support." Firms that make the cut include homebuilder Toll Brothers (NYSE:TOL), steel company Quanex (NYSE:NX), industrial ceramic technology specialist Ceradyne (NASDAQ:CRDN), and Black & Decker (NYSE:BDK).

Those holdings may seem promising, but the fact remains that Shepherd sports a load near 5%, a hefty 2.25% expense ratio, and has been thumped by the S&P 500 in recent years.

Steer clear of duds
The bottom line here is that among the 8,000-plus mutual funds out there, a lot are stinkers. Nearly 1,000 qualify as 3-Alarm funds. If you're looking for some funds on your own, pay close attention to each candidate's returns over the years, along with fees and management's philosophies.

But good mutual funds remain a great way to maximize your wealth. Fool fund analyst Shannon Zimmerman writes his Motley Fool Champion Funds newsletter to help investors do just that. By focusing on long-term performance, low fees, and smart management, he's found 30 Champs that are besting their comparable indexes by an average of nearly 8 percentage points. Also, his Conservative, Moderate, and Aggressive model portfolios are all beating their benchmarks.

To get this month's issue with subscribers as soon as it releases today at 4 p.m. EST, take a 30-day free trial. You'll immediately know about one outstanding mutual fund, and there is no obligation to subscribe. Click here to learn more.

Selena Maranjian's favorite discussion boards include Book Club , The Eclectic Library, and Card & Board Games. She owns shares of no company mentioned in this report, though she does possess a DeWalt cordless drill, made by Black & Decker. For more about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.