When Investors Misuse Quality Funds, Part II

In last week's Five-Star Investor, we looked at how investors have mistimed their purchases and sales of some notable U.S. stock funds, such as  Fairholme (FAIRX) and  Artisan Small Cap Investor (ARTSX). To do so, we used a statistic called investor return, which attempts to depict the return the typical investor earned in a fund, factoring not just what the securities in the portfolio gained or lost but also the timing of investors' purchases or sales. In many cases the 10-year annualized returns achieved by investors were a point or more lower than those achieved by the funds they owned. 

Often this gap was attributable to investors piling into hot funds after the strongest gains had already happened or leaving funds that had performed poorly, thus missing out on any rebound that might have followed. In some cases the gap can be quite dramatic, as we saw with some of the domestic large-cap and small-cap funds we examined last week.

One lesson these investor return numbers provide is the importance of understanding and being comfortable with how management is running your fund. If a manager uses long-term strategies, short-term volatility might not matter to him or her, so investors must bear this in mind if things get rocky. If a manager likes to make large sector bets, investors in that fund should be comfortable with the large swings up or down that can come with such an approach.

This week we turn our attention to the foreign-stock and taxable-bond fund categories. Below are examples of funds our analyst team likes and that have large total return/investor return gaps, along with why they happened. And next week we'll look at the other side of the coin: funds in which investors outperformed their funds and why.   

Foreign Stock
 Dodge & Cox International Stock (DODFX)
Morningstar Analyst Rating: Gold | 10-Year Annual Total Return: 8.10% | 10-Year Annual Investor Return: -1.82% | Investor/Total Return Gap: 9.91 Points 
A prodigious asset gatherer from 2004 through 2007, this fund lost 47% in 2008, putting it in the 82nd percentile among foreign large-blend funds and sending some investors for the exits. They missed out when the fund was in the top 6% of category returns in 2009 and 2010. During the past decade, the fund's net assets have expanded from $117 million to $36 billion, but the its asset base was quite small when it notched some of its strongest gains--returns of 49% and 32% in 2003 and 2004, respectively. Morningstar fund analyst Gregg Wolper recommends the fund based on its deep and experienced management team, its low fees, and its long-range, value-oriented approach.

 Fidelity Spartan International Index 
Morningstar Analyst Rating: Silver | 10-Year Annual Total Return: 5.13% | 10-Year Annual Investor Return: -0.20% | Investor/Total Return Gap: 5.33 Points 
This fund tracks the MSCI EAFE Index of stocks from large developed markets outside the U.S., and its 10-year annualized return (5.1%) far outpaces its five-year annualized performance (negative 5.9%). Meanwhile its asset base grew from $346 million in 2002, around the start of the 10-year period, to $4.8 billion in 2007, around the start of the five-year period. Many investors left the fund in 2011, when it lost 12.2% and its asset base shrank from $6.7 billion to $3.8 billion. These outflows might also be due in part to the fact that the fund does not hold emerging-markets stocks, making it less attractive as a core holding. Those that have stayed with the fund saw a 3.5% gain through the first six months of this year. Wolper likes the fund's ability to track its index closely and its low expense ratio. 

Taxable Bond
 Loomis Sayles Bond Retail (LSBRX)  
Morningstar Analyst Rating: Gold | 10-Year Annual Total Return: 9.91% | 10-Year Annual Investor Return: 4.56% | Investor/Total Return Gap: 5.35 Points 
This fund delivered top 15% performance in the multisector bond category every year from 2002-07, helping its asset base expand from $71 million to $7.5 billion during that time. Then 2008 came along, and the fund's 22.1% loss caused assets to flow out of the fund just prior to its 36.8% rebound the following year. Morningstar analyst Michael Herbst likes the fund's experienced management team and its process of buying bonds and currencies it believes are underpriced. 

 Fidelity New Markets Income (FNMIX)
Morningstar Analyst Rating: Silver | 10-Year Annual Total Return: 12.61% | 10-Year Annual Investor Return: 8.38% | Investor/Total Return Gap: 4.23 Points 
After double-digit returns from 2002-06--including a 31% gain in 2003--this emerging-markets bond fund suffered an 18.2% decline in 2008, prompting a drop in net assets from $2.1 billion to $1.4 billion. Then came 2009 and a 44.6% gain that swelled net assets to $2.9 billion. The fund, from a category that has enjoyed strong inflows recently, has continued to increase assets and now stands at $5.5 billion. But five of the fund's six best-performing years during the past decade took place in the first half of the decade, when its asset base was much smaller. The fund is led by John Carlson, Morningstar's 2011 Fixed-Income Manager of the Year, and analyst Miriam Sjoblom likes his consistent approach and the fund's low cost.

Performance data as of June 30.