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Funds to avoid
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January 28, 2002: 12:05 p.m. ET
Red flags can help you separate the wheat from the chaff.
By Annelena Lobb
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NEW YORK (CNN/Money) - It's a rare mutual fund investor who can avoid bad picks altogether. Even the most market-savvy investors have owned their share of lemons.
And while it's hardly reasonable to expect double digit gains for every fund you hold, there are certain strategies you can employ to help improve your odds. After all, knowing which funds to avoid (or dump, if you already own) is half the battle.
Keeping up with the Joneses
If you're scouring your portfolio for slackers, it's best to begin by comparing a fund's return to that of its peers. Those that consistently perform poorly, especially over several years, don't belong in your bag of tricks.
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 MUTUAL FUND RED FLAGS
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Funds that lag their peers.
Funds with high expense ratios.
Asset bloated small- and mid-cap funds.
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"The manager could have made a large sector bet that flopped; he may have made a large commitment to the fund's top 10 holdings, which then underperformed; or the fund may simply have an unskilled manager, someone who can't pick well," said Doug Fabian, editor of investing newsletter The Maverick Advisor and author of Fabian's Lemon List, a list of underachievers in the fund world.
Fidelity Aggressive Growth has been in the bottom 10 percent of large-cap growth funds based on its 11.02 percent loss over the last 3 years, according to Morningstar. (This fund earned the dubious honor of a spot on Fabian's Worst Offenders list for last quarter.)
"The problem is clearly in the fund's top 10 holdings," Fabian said. "7.5 percent of its funds are in Ciena, its top holding, down 78 percent last year. Its second-largest holding is BEA Systems - it was down 75 percent for last year. Nine of the 10 stocks in its top 10 are down."
Trimming the fat
Bear in mind that returns can also suffer because the fund has become too bloated with assets, making it tough to stay nimble. "Some of the higher-turnover areas, like small blend funds and mid-cap growth funds, have a problem delivering comparable returns to their peers when too much money flows into the fund," said Scott Cooley, a Morningstar stock analyst.
"If you have a fund manager who only wants to hold 20 names, for example, and too much money flows in, then you've got a problem," said Greg Brewer, manager of mutual funds research for Value Line, Inc. "You can only put so much into those 20 names. Then the fund either has to close to new investors or has to change its strategy and invest in more companies. At that point you have to wonder if you're getting the manager's 20 best ideas, and then a few average ones."
Janus Twenty was one such bloated fund. It lost 57 percent of its value from March 2000 to the end of October 2001, due largely to its exposure to technology, telecommunications and media companies. But fund fat complicated the matter as well, according to a report by Morningstar analyst Christine Benz. When repositioning the fund, she said, manager Scott Schoezel dumped huge volumes of certain stocks into the market, further depressing their share prices.
Another example of a fund that got too big for its britches is PBHG Growth, in the bottom 10 percent of its category, with a 2.5 percent five-year loss.
"From 1991 to 1995, it was a very successful small-cap growth fund," said Paul Herbert, a mutual fund analyst at Morningstar. "As it got more attention and a greater inflow of money, it became difficult for (fund manager) Gary Pilgrim to continue focusing on small- and mid-cap stocks." PBHG Growth jumped from $750 million in assets in 1994 to over $2 billion in 1995, and about $5.9 billion in 1996. In 1997, it lost 3.3 percent; in 1998 returns were barely positive, and performance has been in the red ever since.
"Investors who are in an actively managed small-cap fund that has had high returns for several years and has grown in size should expect management to eventually close the fund to new investors," Herbert said. "Two examples of funds that did this are Dreyfus Mid Cap Value and Artisan Mid Cap Value, which announced they were closing in early 2002."
Too expensive
According to Brewer, it's important to remember that a mutual fund is not a single investment in and of itself.
"Buying a mutual fund means paying someone to go out and invest for you," he said. "If the fund's expense ratio is very high compared to its peers, you'd better be getting something significantly above average from the fund. If you're not, then there's no reason to spend the money."
Expense ratios are defined as the percentage of assets that are spent to run a mutual fund, including management and advisory fees, overhead costs and advertising fees.
Keeping expenses low is especially important in the case of bond funds, said Paul Herbert, an analyst at Morningstar. "A risky growth fund with high expenses may still generate huge returns over time. But bond funds typically yield far less than stock funds, so high expenses can be particularly crippling," he said. "It eats into the investor's income."
High expenses have hurt bond funds like Liberty Income, with an expense ratio of 1.22 percent, and Phoenix-Duff and Phelps Core Bond, with an expense ratio of 1.17 percent, said Herbert. Phoenix-Duff and Phelps Core Bond has been at the 70th percentile for its category over the past 3 and 5 years; Liberty Income has stayed between the 70th and 85th percentile for its category over the past 3 and 5 years. The average expense ratio for intermediate-term bond funds is .99 percent, according to Morningstar.
"If a fund's performance is mediocre, or the fund is having other troubles, average to above-average expenses don't help," added Bridget Hughes, an analyst at Morningstar.
Hughes cited Federated International Equity, with an expense ratio of 1.54 percent and a 5.5 percent front-end load, and Old Westbury International, with an expense ratio of 1.49 percent and a 4.5 percent front-end load, as examples.
"Federated had two good years in 1998 and 1999, but before that its performance was middling at best, and in the past few years, it's been doing pretty badly. With the exception of two good years, Old Westbury International has been in the bottom third of its category," Hughes added. 
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