April's Mutual Fund Red Flags

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

A fund having a tough stretch does not necessarily turn us off. That's because a fund's past performance does not predict its future returns. In addition, a fund's style can be out of favor for years at a time, and even our favorite managers go through slumps. It stands to reason, however, that the results of management's work ought to show up in a fund's returns. Funds that have landed in a category's bottom quartile over the first three to five years of a new manager's arrival bear revisiting. With that in mind, let's take a closer look at several funds that have lagged the competition under current management.

Vanguard U.S. Growth VWUSX
Alan Levi and a team from AllianceBernstein manage one sleeve of this subadvised fund, and John Jostrand and a team from William Blair oversee the other. Despite a strong 2005, the fund's 6% and 9% annualized gains over the trailing three- and five-year periods through March 2008, respectively, land in the large-growth category's basement. A big slug of hard-hit financials holdings such as JPMorgan Chase JPM and Lehman Brothers LEH kept the fund on the sidelines of 2007's brief large-cap rally. Both teams focus on firms' fundamentals such as competitive advantage and returns on equity. Although they have produced decent (if not outstanding) results at their individual charges, AllianceBernstein Growth AGRFX and William Blair Growth BGFIX, their combined showing here has been unimpressive.

American Century Ultra TWCUX
Tom Telford stepped into the manager role here in 2006 after a lackluster stint at American Century New Opportunities II ANOAX. American Century's new growth CIO Steve Lurito joined him in August 2007 as comanager. After a solid 2007, the fund has given back much of its gains and its annualized return of 6% on Telford's watch from June 30, 2006, through March 2008, falls behind the pack (with high volatility). The team employs a momentum-oriented style that leaves investors susceptible to sharp and sudden downturns, as evidenced by recent sharp pullbacks on top holdings including Google GOOG and Apple AAPL. Heavy redemptions have added to Telford and Lurito's challenges as of late.

Ariel Appreciation CAAPX
This fund's 11% annualized gain over the trailing five years through March 2008 is certainly not terrible in absolute terms, but it falls behind 85% of its midcap blend category peers. Skipper John Rogers took the helm here in October 2002 and was joined by comanager Matthew Sauer in late 2006. The duo eschews cyclical companies, so the fund has not benefited from the energy and industrial materials rallies that stole the show during most of their tenure. Rogers and Sauer want stocks trading at deep discounts and are apt to add to holdings such as mailing services provider Pitney Bowes PBI as they're taking it on the chin. That approach has given Rogers' other charge, Ariel ARGFX, plenty of armor in tough markets, and we'd expect that advantage to reveal itself here over the longer haul.

Janus Worldwide JAWWX
Jason Yee took this fund over after meeting with some success at his smaller charge Janus Global Opportunities JGVAX. Yet this fund's 9% annualized return over the trailing three-year period through March 2008 trails three fourths of its world-stock category rivals. We'd attribute part of that showing to the fact that Yee largely steers clear of emerging markets. The fund has also gotten socked by the market's mortgage woes due to holdings such as homebuilder Centex Corporation CTX and Citigroup C. Lastly, the portfolio includes several troubled turnaround stories, such as Sprint Nextel S. The fund might take more lumps should the economy take another turn for the worse, and we'd understand if investors looked to more proven options.

Andrew Gogerty is a mutual-fund analyst with Morningstar.