When bad returns don't make a bad fund

Good managers can look lousy when the sector they invest in is out of fashion. But fashions change.

By Penelope Wang, Money Magazine senior writer

(Money Magazine) -- Last month I got an e-mail from a reader really giving it to me: "How can you possibly continue to have Jensen on your [Money 70 recommended fund] list?" he asked. "I just couldn't keep the dog in my portfolio, so I sold it."

Jensen (Charts) has been a laggard, true enough. But too bad about the timing of that sale. More often than not, the best move to make with a lagging fund is to do nothing. A fund may go into a slump simply because its strategy is out of favor on Wall Street. Eventually the market will shift, and your dog will again have its day.

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Feedback: pwang@moneymail.com

That is exactly what happened with Jensen shortly after this e-mail arrived. Here's the backstory: Jensen focuses on supersize stocks that increase their earnings at a better than average clip - think General Electric or Microsoft. For more than six years, investors have more or less ignored these behemoths in favor of funds that invest in bargain-priced small stocks and real estate. So it's no surprise that Jensen's returns have been lousy and that other large growth funds have mostly delivered blah numbers too.

But since the spring, and even more so with the arrival of the market's summer meltdown, the picture has reversed - last year's chart-topping funds have been hammered, while large growth funds in general, and Jensen in particular, are holding up well.

For the three months through Aug. 10, Jensen's 0.2 percent loss outpaced the S&P 500 by nearly two percentage points. And so far this year the typical large growth fund is ahead by 14.1 percent vs. a 0.7 percent gain for small value funds.

Now whether that trend continues in the near term is anyone's guess. But the prices are right. Large growth stocks are selling at an 13 percent discount to their historical valuations, compared with a 37 percent premium for small value companies, according to the Leuthold Group, an investment research firm.

The latest economic worries, including the subprime turmoil and rising energy prices, may also work in favor of a large growth rebound - during an economic slowdown, investors tend to bid up stable blue-chip stocks. These trends have encouraged top managers who don't normally focus on big growth stocks to scoop them up.

Among them: David Katz of Matrix Advisors Value (Charts), Charles Mangum of Fidelity Dividend Growth (Charts) and the team at Madison Mosaic Investors (Charts), all MONEY 70 funds. Says Katz, who has large stakes in Microsoft (Charts, Fortune 500) and Johnson & Johnson (Charts, Fortune 500): "This absolutely is the most compelling area of the market."

The trick for you is to reposition your portfolio to take advantage of a large growth rebound without going overboard and setting yourself up for a fall if growth stocks' favored-son status disappears again. Take these two steps:

  • Review your large growth allocation. If you have a big chunk of your portfolio in an S&P 500 index fund, you're good to go - you own a little of everything. But if you've been chasing performance of late by ignoring big stocks in favor of small ones, or you've held only large-cap value funds, which were also hot over the past few years, move money into large growth. It should make up half of your large-cap allocation.
  • Look beyond the label. Large growth funds don't all invest in the same way. Jensen owns just 25 stocks, so a few picks can send it soaring or sinking. By contrast, T. Rowe Price Blue Chip Growth (Charts) holds more than 100 stocks, which gives you a smoother ride, though a bit less potential for an outsize gain. The T. Rowe fund places in the top half of its peer group year after year. Jensen, on the other hand, tends to be at the very top or near the bottom.

For my letter writer: The fact is, if you're well diversified, your assets won't move in sync, which means some of your funds will underperform the market at any given time. Yes, you should sell a laggard that's been stumbling for an extended period when its competitors are doing well. But if the fund's peers are lagging the market too, then most likely the sector your fund invests in is just out of fashion. That will change someday. And the last thing you want to do is bail out the day before someday arrives. Top of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.