Four Funds on the Rebound: Should You Stick Around?

What happens when a long underperforming fund shows signs of life? Is it proof that it's turned the corner and your patience is finally being rewarded, or are you being tricked into holding on only to suffer through a second bout of underperformance?

Figuring this out is one of the tougher challenges facing mutual fund investors. So, I'll look at four cases of big funds that are showing signs of life for the first time in years. Each fund produced top-third returns for the trailing 12 months, yet still has an ugly five-year performance record. Taken at face value, it's great to see these funds finally making up ground for shareholders, but it can also make it tougher for shareholders to cut the string.

The key in these cases is to take a close look at the fundamentals underlying the rebound to see if there really has been an improvement in areas such as management, expenses, or strategy. If you're not convinced, then it's probably time to move on.

 American Century Giftrust 
If this is a head-fake, it wouldn't be the first for this aggressive fund. After three straight bottom-decile performances from 1996 to 1998, the fund produced top quartile returns in 1999, only to spend four of the next five years in the bottom quartile. In 2005, it put up a truly impressive 22.05% return.

Also encouraging is that the performance came as a result of a change in management and strategy in 2004. New comanager David Rose tweaked the fund's momentum models and made them quicker to sell so as to get ahead of the crowd. Rose also had success in turning  American Century Vista  around. In all, the fund may have turned the corner, but there are a couple of things that give me pause.

First, momentum funds seem to have a harder time maintaining their success than do other funds. Second, this fund is tough to get out of once you're in. It takes a good amount of paperwork and there's not much point to sacrificing ease of sale when there are plenty of other good funds around. So, if you're already in and your child's college savings aren't all wrapped up in this one fund, it might be worth holding on, but otherwise don't bother. Rose also runs  American Century Heritage (TWHIX), so you can tap his skills there without locking yourself in.

 Fidelity High Income (SPHIX)
This one is definitely worth holding on to despite the fund's crummy five-year record. There's plenty of evidence of improving fundamentals, and the fund's poor performance is growing smaller in the rearview mirror.

The fund suffered nasty losses of 14.2% in 2000 and 4.8% in 2001, but since then it has been a pretty good performer. The fund got burned by debt from telecommunications companies, which had borrowed up to their eyeballs in order to lay more fiber-optic cables than the world will ever need. However, Fred Hoff came on in mid-2000 and has toned down the fund's big bets and emphasized individual issue selection.

Also encouraging is the fact that Fidelity's efforts in high yield have paid off in other funds, so there's good reason to believe there has been a fundamental improvement. Our bond analysts have visited Fidelity's high-yield group in Boston a few times, including this January, and have become more comfortable with management over time. Moreover, the fund charges a low 0.77%, providing another boost to returns.

 Putnam New Opportunities A (PNOPX)
Like Fidelity High Income, this fund has improved significantly since putting up awful returns in 2000 and 2001. However, we're still wary because the overhaul of Putnam's growth team is still a work in progress. Unlike the Fidelity fund, which has had the same manager since 2000, this fund's three managers came on board in 2004 and 2005, and the fund lost a manager in July 2005.

Much of the rebound has been driven by Putnam's improved work on small- and mid-cap stocks, but we're not as sure this team will be as successful picking large-cap growth stocks in this all-cap strategy. We'd stay on the sidelines.

 Vanguard U.S. Growth (VWUSX)
Welcome to Vanguard's albatross. Despite a couple of manager changes and Vanguard's trademark low costs, the fund couldn't climb out of the basement. The fund underperformed in every single calendar year starting in 1999 and running through 2004, before the streak was finally broken in 2005.

In mid-2001, Vanguard moved the fund from Lincoln Capital to AllianceBernstein, and in 2004 it carved out about a third of the fund's assets and turned them over to William Blair. Although their record on this fund has not been stellar, I am impressed with AllianceBernstein's efforts to improve its growth side. The firm has significantly ramped up analyst hiring and devoted sizable resources to in-depth studies of key developments affecting growth companies such as China and broadband.

So, there are fundamental and performance signs of a rebound. However, we'd like to have a little more evidence of their successful stock selection before diving in. Consider it one to watch in the meantime.