Don't Invest Like This Pension Fund!

Earlier this week, the Massachusetts state pension managers decided to join the crowd and fire Legg Mason's (NYSE:LM) Bill Miller, along with a few other managers from top investment firms. The event likely didn't have the flair of a Donald Trump boardroom brouhaha, but the fact that the state instead opted to entrust most of its new cash to a passively managed index fund is a slap in the face to Miller and crew.

Then again, maybe the debacle did have the wrath of a boardroom battle, judging by these harsh comments from Michael Travaglini, director of the Massachusetts Pension Reserve:

• "'[U]tilizing traditional long-only equity managers has not added value over [the last 24 years].'" (The Wall Street Journal)
• "'We've determined that active managers add no value over long periods of time. ... The domestic equity structure is not working.'" (Bloomberg)

Ouch!
I'll cut the guy some slack -- he's understandably frustrated by these money managers' recent underperformance. Plus, indexing can be a very smart approach -- even Warren Buffett believes index funds have an advantage over money managers.

But in my opinion, Travaglini couldn't be more wrong to give up on these top money managers during a tough market (particularly for value investors). That goes double when the retirements of so many hardworking teachers and civil servants are on the line.

Don't just take my word for it
A recent study released by Baird's research division backs up my belief. The report determined that more than 80% of high-performing managers go through at least one three-year period wherein they lose to the market.

Even more startling, nearly 90% of high-performing funds experienced a three-year period of losing to their peers. The study's conclusion is clear: "There is an extremely high probability that an investor will own a high-performing mutual fund that will go through at least one sustained period of poor performance not only relative to its benchmark, but also relative to its peers."

So, yes, even the best money managers post poor results from time to time. But how do investors typically react to those periods of underperformance? Not very wisely, Baird's study suggests.

Investors tend to withdraw their money when a high-performing fund hits a rut, opting instead for a fund with better recent results. From the study: "Investors appear to be buying high (funds coming off a strong period) and selling low (funds coming off a weak period)."

Actionable advice
I may not be able to persuade Travaglini to take Miller et al back -- although I think he should, because that was a particularly impressive assembly of fund managers -- but hopefully I'll be able to prevent you from making a similar mistake.

See, even the smartest Wall Street minds will have periods of difficulty and underperformance. And if you've found a top-notch fund manager, these periods of weakness are generally followed by market outperformance: All of the funds in the Baird study outperformed both the market and their peers over a 10-year time frame.

So what can you do with this information? Three things:

1. When looking for new funds, the manager is among the most important things to look at. Look for a long tenure, long-term outperformance, a consistent strategy adhered to in good times and bad, and previous experience in bear markets.
2. If you own a fund run by a proven manager but you're considering selling because of recent performance that disappoints, think twice about moving your cash elsewhere.
3. If you have extra cash you'd like to deploy to a top-notch mutual fund manager, now is a great time to get in.

As a place to start, here are two funds run by brilliant long-term managers that we at Motley Fool Champion Funds believe have merely experienced short-term difficulties. And, in spite of those difficulties, I believe they will outperform when the markets turn upward.

Morningstar data as of Aug. 6, 2008.

Of course, these aren't the only two funds that would make a smart choice for investors seeking long-term wealth appreciation. If you'd like to browse through our entire list of recommended funds at Motley Fool Champion Funds, click here to try the service completely free for the next 30 days.

Adam J. Wiederman owns shares of Legg Mason, but of no other company mentioned above. The Motley Fool also owns shares of Legg Mason, which is an Inside Value recommendation. Dell and Intel are also Inside Value picks. JPMorgan Chase is an Income Investor pick. Muhlenkamp is a Champion Funds recommendation. The Fool's strict disclosure policy is here.