A year ago, The Washington Post published a mournful report on William Miller, who as manager of Legg Mason Value Trust (LMVTX) had beaten the market for an unprecedented 15 consecutive years but then seemed to lose his touch. In last year's first quarter, his fund suffered its worst three months ever. By the end of 2008, his investment company was laying off staff members as shareholders were leaving in droves.
This year the fund is trouncing the market, and investors who sold are losing out again.
Also on the rebound are a number of other portfolios managed by Miller and his colleagues, who, it turns out, hadn't suddenly gotten stupid.
The same thing is occurring throughout the mutual fund industry, where scores of brilliant managers are showering double-digit gains on shareholders who were willing to endure a brief but terribly painful period of underperformance. And on investors who looked at the long-term results, rather than the short-term records, and bought in.
It's an important lesson in when not to sell and, looking forward, a buying opportunity, since these great funds remain relatively cheap.
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Bad years are inevitable
Another legendary manager coming in from the woodshed, Christopher Davis of Davis Opportunity B (RPFEX), predicted this exact scenario several years ago in a speech at the annual Morningstar investment conference in Chicago. Every top-drawer manager, he said, is likely to underperform for three consecutive years out of any 10. No sooner did he say it than his fund took exactly such a dive, plunging to the 84th percentile of similar funds last year, only to surge to the 19th percentile this year.The reason is that markets are rational -- their movements make sense -- only over very long periods. In the short term they can be extremely irrational, and that has been particularly true over the past three years. After years of excessive risk taking by the herd -- banks, borrowers, investors, consumers, etc. -- the market decided to dole out excessive punishment for taking risks. And risk is what mutual fund managers are paid to take.
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That's why you should never sell a mutual fund simply because its performance, even when compared with funds investing in similar stocks, takes a dive. In fact, expect it to underperform from time to time, especially when markets seem unusually wacky. You are apt to get your greatest profits soon after huge numbers of your fellow shareholders have bailed out.
So how do you evaluate a fund? Look for performance in the top 25% of similar funds over the longest possible periods -- at least five years and preferably at least 10. And, of course, you need to make sure it's been under the same management that entire time.
Continued: Top-tier turnaround funds
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