Are These Funds Naughty or Nice?

Does your holiday stocking include a lump of coal or a diamond?

To help investors decide which investments they should cut loose and which they should hang on to as they rebalance, take tax losses, and upgrade the quality of their portfolios, we constructed two  screeners. The first focuses on mutual fund diamonds in the rough: investments that are better than they look right now. The second homes in on funds that are the investment equivalent of lumps of coal--funds with a combination of poor stewardship and weak investment merit.

Diamonds in the Rough
Our first screener focuses on finding offerings that, despite their recent performance hiccups, are worth keeping for the long haul. We searched for no-load domestic-stock funds with fees below the category average. We also layered on a screen for managers with more than 10-years of experience. And to help distinguish long-term winners with short-term performance problems, we asked for funds that land in the top quartile of their categories for the 10-year period but lagged half their peers in their three-year trailing performance. To further whittle down the list, we required Morningstar Ratings of 3 stars or greater, and we only called up the distinct portfolios of funds. This screener yielded eight funds, and we highlighted two below. Premium members can  click here to replicate the screen. 

 Selected American Shares (SLASX)
This fund is a standout steward with top marks across the board for corporate culture, board quality, manager incentives, fees, and regulatory issues. It's still playing catch-up on recouping the huge losses it incurred during the last market downturn. But management's disciplined application of its investment strategy still makes it a worthy contender for a core holding. Management focuses on solid companies whose shares are trading below their estimates of fair value, and being a stickler for strong fundamentals and reasonable valuations should pay off over time. Moreover, the fact that the fund has never trailed the S&P 500 in any rolling 10-year period since the start of the senior team members' tenure presents yet another a strong case for this fund.

 Stratton Small-Cap Value (STSCX)
It's difficult to fault this fund's recent streak of underperformance. Manager Gerald Van Horn uses a measured strategy, employing a quantitative model that seeks stocks with low valuations relative to their cash flows as well as positive share-price momentum and upward earnings estimates. He then delves into the companies' fundamentals to identify those that have a catalyst to drive future growth. While these elements have held the fund back during market rallies that favor rebounding lower-quality names--as in 2009 and so far in 2010--the strategy provided excellent downside protection, landing the fund in the top 3% of its peers during 2008's market tumble. Consistency also gives this fund a leg up. For Van Horn's 10-plus-year tenure, the fund's 10.6% annualized returns outpaces the category average of 6.1%. Although a compact portfolio and large sector bets court additional risk, this fund is worth a look.

Pass on These Investment Duds
To dig up domestic-stock funds that are the investment equivalent of a lump of coal, we started by using our  Premium Fund Screener to identify poor-performing funds. Specifically, we screened on offerings that rank in the bottom quartile of their peer groups for the trailing 10-year period and below half of their peers for the trailing three-year period. We homed in on funds that had a Morningstar Rating lower than 3 stars and also have Morningstar Risk ratings of average, above average, or high. We also focused on those funds that have exceedingly poor Stewardship Grades--below a C. When focusing on single share classes for each offering, the screener yielded a list of five funds, two of which we highlight below. To replicate this screen,  click here.

 AllianceBernstein Growth & Income (CABDX)
While consistency is usually a heralded virtue, the only consistency with this fund is its pattern of lagging its peer group. The fund experienced steep losses in 2008 as a result of its stakes in troubled holdings such as Fannie Mae (FNMA) and Freddie Mac (FMCC), but unlike other funds in a similar boat, it never made a comeback. Since lead manager Frank Caruso took over the fund in late 2004, it has trailed its typical large-value peer in every calendar year but one, 2007. Furthermore, the fund receives a Stewardship Grade of D because of AllianceBernstein's corporate culture and manager incentives that don't clearly align with fund shareholders' interests. Investors have little reason to keep this fund around in their portfolios.

 Putnam Small Cap Value (PSLAX)
Manager Eric Harthun took over as sole manager for this fund year ago, but it's too soon to say the fund is on the rebound. Unlike his predecessor, Harthun isn't a strict contrarian; he also wants to see catalysts that can spark positive change before buying in. That could mark a step in the right direction, but it's too soon to tell how well he and his team will execute. Moreover, the fund earns a Stewardship Grade of D owing to weak grades for corporate culture and manager incentives that are too short-term in nature. Change may be on the horizon for this fund, but it would behoove investors to keep an eye on its progress before making any commitments to this offering.