When to Dump a Losing Mutual Fund

A new study says investors should hold their lagging mutual funds for at least three years.
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NEW YORK (TheStreet) -- After the rollercoaster markets of recent years, plenty of investors face a difficult question: When should you sell a lagging mutual fund?

Some financial advisers suggest waiting for a year or two to see if the manager can return to winning ways. But a new study says investors should hold their weakest

funds

for at least three years. Investors who switch funds frequently are likely to reap miserable returns, according to the study by Matthew Rice and Geoffrey Strotman of

DiMeo Schneider

, an investment adviser in Chicago.

For the study, the researchers looked at the performance of

mutual funds

that had finished in the top quarter of their

Morningstar

(MORN) - Get Report

categories for the 10 years ending in 2009. Most of those funds outdid their benchmarks by wide margins, and shareholders should have been pleased with the results. But even those winners faced significant periods of underperformance. Altogether, 85% of the winning funds had at least one three-year stretch when they ranked in the bottom half of their categories.

In other words, even the best managers have long spells of poor performance. So when you buy an actively managed fund, you must be prepared to sit tight for years when the manager looks inept.

All too many investors simply don't have the patience to wait for recoveries. They buy a manager with a hot record. When the fund turns cold, they sell and switch to another hot fund. Most often this approach fails because investors tend to buy hot funds when they are peaking and about to enter periods of underperformance.

If you know you can't stand firm during long periods of weak performance, you should consider giving up on active managers, who try to beat benchmarks. Instead, impatient investors may get better results by relying on index funds.

But the study cautions that index funds can be frustrating too. During the past decade, most actively managed stock funds outdid their benchmarks. Large-cap funds had a particularly strong showing. Of large value funds, 63% surpassed the

Russell 1000 Value Index

, while 81% of large growth funds outdid the

Russell 1000 Growth Index

.

The active managers did well because they tend to excel during the kind of market downturns that occurred in the past decade. In roaring bull markets, active managers often lag. This occurs partly because active managers often hold some cash. The cash acts as a cushion in down markets -- and a drag in good times. In contrast, the benchmarks include no cash.

Another explanation for the recent performance of active funds is that most benchmarks are weighted according to market capitalization. Under this system, big stocks account for more assets in the benchmark. Consider that in 2008,

Exxon Mobil

(XOM) - Get Report

alone accounted for 8% of the Russell 1000 Value Index. Few active managers would have such a big weighting in any one stock. So when Exxon and a few giant stocks sink, the benchmarks could lag active managers. That can often happen during bear markets. In good times, a few giant holdings can help index funds outdo active managers.

Even in bull markets, index funds can perform erratically because of the way many are designed. Unable to hold every issue in their benchmarks, some index funds own a sampling. This sometimes results in underperformance. Consider that

Barclays Capital Aggregate Bond Index

, a popular fixed-income benchmark, includes 8,300 bonds. Because it is difficult to buy every one, the

iShares Barclays Aggregate Bond Fund

(AGG) - Get Report

, an ETF, owns only 275 securities. Because of the limited sampling, the ETF lagged its benchmark by 0.82% in 2009.

Faced with such problems, investors need to exercise caution before buying any fund, whether it is active or passive. When evaluating active funds, look at how the fund has performed relative to its benchmarks in the past. Cautious investors may prefer sticking with steady funds that excel in downturns and avoid finishing near the back of the pack most of the time.

For a reliable active fund, consider

Eaton Vance Large-Cap Value Fund

(EHSTX) - Get Report

, which holds such steady blue-chips as hamburger giant

McDonald's

(MCD) - Get Report

and

Hewlett-Packard

(HPQ) - Get Report

. During the past 10 years, the fund has returned 5.5% annually, outdoing 86% of its large-value competitors.

Eaton Vance

(EV) - Get Report

finished in the top half of its category during eight of the past 10 years.

For a large growth choice, consider the

American Funds AMCAP Fund

(AMCPX) - Get Report

, which owns such profitable companies as

Oracle

(ORCL) - Get Report

and medical device maker

Medtronic

(MDT) - Get Report

. During the past decade, the fund has returned 2.4% annually, outdoing 94% of competitors. The fund has finished in the top half of its category in nine of the past 10 years.

--

Written by Stan Luxenberg in New York

.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.