3 great funds that only look lousy

By Tim Middleton

Some really great mutual funds are on sale.

Actually, the entire global stock market is about 20% off its peak of October. But the funds I'm talking about are cheap even compared with that. In one case, an epoch-making fund is hemorrhaging assets because of its lousy performance. And the lousy performance is exactly what makes it so appealing.

The conventional wisdom that warns you away from underperforming funds has got it backward. The very best mutual funds are practically guaranteed to underperform some of the time, for the same reason that they outperform most of the time: Their managers are smarter than other investors. Eventually the herd catches up with them, but it can take a while.

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So if you're frustrated by the lack of attractive investment opportunities at the moment, let me suggest three: Davis New York Venture (NYVTX), Legg Mason Value Trust (LMVTX) and Bridgeway Small-Cap Value (BRSVX).

But first, the background. Investment company Litman/Gregorystudied the performance of large-capitalization mutual funds from 1996 through 2005. Among the funds that outperformed their rivals for the entire 10 years, more than 90% had lagged the field by at least 2 percentage points for three years. Roughly two-thirds had lagged by at least 5 percentage points.

You can find this research at Davis New York Venture's Web site, where a co-manager of the fund, Christopher C. Davis, adds this commentary: "There is an old saying that one year of poor performance is understandable, two years troubling and after three, it is time to make a change. Investors who believe this nonsense are ensured poor long-term results as they are nearly certain to fire every top-performing manager of the decade based on the inevitability of three-year dry spells."

Davis hits a dry spell

When Davis posted this last summer, his fund was actually riding a seven-year high during which its annualized return of 5.7% had trounced the S&P 500 Index's ($INX) 1.7% gain. Davis added this: "We know our results will not always look as good as they do today and feel it is our responsibility to moderate your expectations when things are going well. We also know that when our three year results are poor, this reasoning may sound like we are making excuses."

The Davis fund has since gotten its comeuppance, finishing 2007 with a gain of just 5%, lagging 60% of its peers. The problem was the fund's chronic huge overweighting of financial stocks, which account for more than one-third of assets. For generations, the Davis family has produced stock analysts with a strong bent toward financials.

So the subprime-mortgage mess is dragging down this fund, which as of Jan. 30 was down 6.1% this year. But Davis isn't about to rejigger his fund because it's unpopular. Turnover is about 5% a year, indicating an average holding period of 20 years.

Legg Mason lags

Davis was Morningstar's domestic-equity fund manager of the year in 2005, but he's practically anonymous compared with Bill Miller, the manager of Legg Mason Value Trust. Miller finished 2005 having beaten the S&P 500 for 15 consecutive years and at his peak was managing $45 billion. I once sat at the next table in a Chicago steakhouse, and it was like those old E.F. Hutton ads: When Miller spoke, people around him strained to catch his every word.

But in 2006 he trailed the market by nearly 10 percentage points, and last year he trailed by more than 12 points, with his fund 6.7% in the red. Assets have shriveled to about $16.5 billion. But, says Morningstar analyst Greg Carlson in an analysis he published in December, "We think it's a good time to buy Legg Mason Value, not sell it."

Continued: A patient investor

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