When a Good Fund Goes Bad

If there were one piece of advice I could give to mutual fund investors, I would urge them to focus on long-term performance when evaluating funds.

Far too many folks base their buying decisions solely on which funds have the best one- or three-year performance numbers. Even good managers can have a stretch of bad performance from time to time, so it's important to focus on the long term. But when do you decide that short-term underperformance has gone on long enough, and it's time to cut your losses?

Bad timing
One fund that presents a perfect example of this dilemma is the Templeton Foreign Fund (FUND:TEMFX). This fund, which invests in both developed and emerging foreign companies, follows Templeton's value-oriented philosophy. As you probably know, the past few years have been very kind to both foreign stocks and to value-oriented stocks. Emerging markets in particular have left domestic stocks in the dust for several years now.

In this type of environment, you might expect a fund like Templeton Foreign, with its value-orientation and hefty exposure to emerging markets, to have outpaced the broad foreign market. But that hasn't been the case. In fact, the fund has trailed the benchmark MSCI EAFE Index every calendar year since 2003, and is trailing just slightly through August 2007.

Unfortunately, Templeton Foreign appears to have been in the wrong place at the wrong time. The fund, largely driven by bottom-up stock picking, has a notable lack of exposure to European stocks, which have been strong performers of late. Instead, the fund has loaded up on less-popular Asian stocks like Mitsubishi UFJ Financial Group (NYSE:MTU) and Taiwan Semiconductor (NYSE:TSM).

While the fund's more conservative nature might explain some recent underperformance, it is puzzling that Templeton Foreign continues to lag as much as it has. Its emerging markets exposure should give it an extra boost compared to its benchmark, since the MSCI EAFE Index only consists of developed markets. The fund has also lagged its peer group. While the average foreign large-value fund in Morningstar has posted a 19.6% five-year annualized return through August 2007, Templeton Foreign Fund is up just 16% during that time.

A new wrinkle
Perhaps not surprisingly, Franklin Templeton recently announced that the fund's lead manager, Jeff Everett, will leave the firm at the end of September to pursue other opportunities. Manager Tucker Scott, who heads up two other Templeton funds, will replace Everett at the helm of Templeton Foreign. The fund will continue to operate with co-managers Lisa Myers and Murdo Murchison on board.

Templeton's management process is very team-based and relies heavily on research from analysts. These analysts compile a central list of all approved stocks from which managers are free to choose. As such, it is unlikely that the fund's strategy will face substantial changes as a result of Everett's departure, but the portfolio may look slightly different in the coming months. After years of lagging performance, the urge to switch things up a bit would be overwhelming for a new manager.

Pull the plug?
So what's a long-suffering investor to do with Templeton Foreign? After all, nothing in the fund's investment process has changed, and the fund has done well on an absolute basis. Furthermore, if foreign markets hit a downturn, Templeton Foreign will likely weather the storm better than most of its peers. All in all, this has been a great fund that has encountered a bit of difficulty the past few years.

I always encourage investors to think of the long term, but continued underperformance in the short term can't be ignored. At this point, it is unclear what it would take for performance at Templeton Foreign to turn around. There may be some changes with a new manager, but improvements might take a while to materialize. If you are a patient investor and believe strongly in Templeton's value approach to foreign investing, you might stick around and see if the fund takes a different tilt under Scott. Similarly, if you don't have a high tolerance for volatile foreign markets, this fund may continue to do well for you.

But for many other investors, enough is enough. The fund has had many years to turn itself around but hasn't. Many other foreign funds would serve as an excellent international anchor in a fund portfolio, so now may be the time to look at alternatives.

It's a tough call to say goodbye to a good fund that is going through a rough patch, but sometimes it needs to be done. After all, short-term underperformance can have a way of stretching into long-term underperformance, if you're not careful.

Related articles:

• Franklin Templeton Takes a Load Off
• The 5-Minute Fund Test