Extreme Times, Disappointing Outcomes

Losses are losses, right? Wrong. Though losses run deep across the board in mutual funds, the collapses suffered by certain funds are particularly disappointing.

In order to locate those unpleasant cases, we've taken a deeper look at what caused the pain for some funds and have matched the results with each fund's strategy and process to get a clearer picture of the cause. The toughest underperformance for us to swallow came in funds that should have--given their strategies--done better in tough times, if not in absolute terms, at least versus their peers.

Tough times haven't led us to change our tune on every fund that has been disappointing. Poor performance alone may lead us to revisit our opinion, but it is certainly not an automatic trigger for a change in our stance. In fact, we're standing behind funds we think have a winning combination of management, strategy, fees, and stewardship to excel over a full market cycle. My colleague Bill Rocco recently highlighted some of these offerings.

There are others, however, whose dismal showings have exposed weaknesses in their approaches. We've cooled on the following three funds as a result.

 Janus Worldwide 
We became fans of Janus Worldwide soon after manager Jason Yee took over in 2004. Yee had successfully managed  Janus Global Opportunities  since 2001 (it was one of few Janus funds to do well in that downturn) and put together a distinctive concentrated portfolio with a decided value tilt here. Yee seemed to be cut from a different cloth than other Janus managers. His portfolio didn't share the aggressive-growth attributes that have come to characterize Janus' other flagship funds and Worldwide's old ways. Cash flows, valuations, and enduring competitive advantages were all a part of Yee's lexicon, and the portfolio took on a refreshing new look.

Times were tough from the get go, however, as Yee positioned Worldwide conservatively when emerging markets and energy drove its peers and several Janus siblings to big gains. He couldn't justify the valuations and kept the fund out of those heated corners of the market. We were glad to see the fund sticking to its knitting, though, even if it meant missing some of the upside. We expected the fund would eventually have its day in the sun when speculation lost its attraction and the market's favor rotated out of emerging markets and energy.

Well, risk-taking is no longer in favor and the market has indeed punished emerging-markets and energy stocks, but this fund continues to lag. What's worse, this environment has poked holes in several of Yee's picks. In 2008, he underestimated the risks facing its financials holdings, such as investment bank  UBS (UBS), government-mortgage lenders  Fannie Mae (FNM) and  Freddie Mac (FRE), and insurance giant  American International Group (AIG), which all tanked as the financial crisis unfolded. In addition, expected improvements at top holdings such as  Dell  and  Yahoo  have yet to materialize. The fund has lost 51% for the 12 months through March 3, 2009, and lags more than half of its world-stock peers.

We would've expected a much stronger showing in both absolute and relative terms, given Yee's approach. His missteps have dimmed our confidence in the fund's ability to be a standout under his watch.

 Artisan Small Cap (ARTSX)
As at Worldwide, this fund's managers employ a sensible strategy that emphasizes fundamental attributes. The team claims to look for sustainable competitive advantages and solid returns on invested capital. Those inclinations are good in theory but haven't led to the kinds of results we'd expect. We were OK with the fund lagging while cyclical commodity-oriented stocks rallied because those kinds of companies are less likely to fit the managers' criteria.

The preferences that held the fund back in the cyclical boom, however, failed to protect it in the market's carnage in the second half of 2008 when highly cyclical--and highly leveraged--businesses were crushed. The fund's holdings proved to be more vulnerable than the managers thought. It bought or added to names such as oil exploration firm Carrizo Oil & Gas  and oil industry boat supplier  Hercules Offshore  in the third quarter, before the bulk of those stocks' declines. The managers declined to comment on recent holdings, but some choices raise concerns. For example, we question whether a firm like Hercules--which dropped 80% in 2008 and has been described by Morningstar's equity analysts as having an ancient, inferior fleet that can't compete for many desirable international contracts--really has competitive advantages.

The fund hasn't performed well in most rallies and has now failed to protect capital at a crucial time. (Its longer-term record is subpar.) In all, we think management's execution of the strategy has been weak.

 Western Asset Core Bond (WATFX)
This fund has been burned by 2008's severe credit-sector and mortgage troubles and some missteps in its team's core competency--credit analysis. Unfortunately, a comeback is not just a matter of the fund's holdings rebounding. Several corporate-bond issuers in the portfolio, such as Lehman Brothers and Iceland's Kaupthing Bank, Glitnir Banki, and Landsbanki, are now in default. Moreover, corporate bonds haven't been the sole or biggest cause for pain. The fund's stake in nongovernment mortgage-backed securities (roughly 20% of assets) has weighed on the fund's performance as well. Further exacerbating those bad calls, the fund's shareholders have been calling it quits at an alarming pace, which places an additional level of pressure on management to find cash to meet redemptions.

The miscues in the portfolio and heavy redemptions are especially concerning in light of some firm-level challenges facing Western Asset. Its highly respected former chief investment officer, Ken Leech, stepped down in August 2008 for medical reasons, just prior to the greatest period of market stress. He was replaced by then deputy-CIO Steve Walsh, and the firm has yet to name a replacement for Walsh's former position. This transition, along with the weak performance in the downturn, makes us uneasy about the fund's prospects. This has been one of our favorite teams for fixed income and while we think there are strengths there that could pull it through, our confidence in the team has been shaken. Western has attempted to address some of these issues by hiring a new chief risk officer, but it's still too early to know whether such efforts will help restore this fund to its prior position of strength.