Funds That Offer the Worst of Both Worlds

As an informed investor, you've probably heard time and again how important it is to keep expenses low while seeking out funds led by managers with solid track records. In fact, keeping expenses low is like the "eat your vegetables" of financial advice--not necessarily the most exciting bit of wisdom, but one virtually guaranteed to pay off over the long term.

If you're a regular visitor to Morningstar.com you're probably also well aware of the correlation between a fund's expenses and its performance. It's only logical that funds that charge shareholders less have a built-in advantage over those that don’t because fees are deducted from returns. So a fund charging 0.25% annually has a built-in 1-percentage-point advantage over a competitor charging 1.25%.

But fees alone don't tell the whole story. For actively managed funds, the skill and experience level of the manager or management team also help determine performance. A manager with these attributes may be better able to anticipate and navigate market turbulence than one who has spent far less time making the crucial decisions that can spell the difference between above- and below-average performance. In some cases, paying a little bit extra in the form of higher-than-average fees might be worth it if you believe in a manager's process and experience. But doing so carries the added risk that the manager will not be able to overcome these higher fees on a consistent basis.

If low fees and strong performance represent a sweet spot of sorts for fund investors, it can also be instructive to look at funds that behave in just the opposite fashion. Funds that charge high fees but have delivered subpar returns represent the worst of both worlds in a sense but serve as a reminder that some investors continue to overpay for underperformance.

To identify such funds, we set the Morningstar  Premium Fund Screener to search for stock funds with bottom-quartile five- and 10-year annualized returns for their categories and above-average expense ratios. We looked only at funds with above-average Morningstar Risk ratings, meaning they tend to experience more downside volatility than their peers, which is something most investors would rather avoid. We applied the distinct portfolio screen to eliminate multiple share classes of the same fund, though in some cases newer, less expensive share classes may be available. We also screened out institutional funds to include only those available to all investors. Some funds on our list also might charge a load, adding to the cost burden imposed on investors for the lousy returns they've delivered. Premium Members can see the full list by clicking  here. Below are three names on the list.

 John Hancock Classic Value (PZFVX)
Running a concentrated, contrarian portfolio and charging above-average fees for bets that often haven't panned out is a good recipe for landing on our list, and this fund is a prime example. Managers screen the 500 largest U.S. publicly traded companies for those that appear undervalued due to earnings misses, bad press, or regulatory issues. Top holding  Hewlett-Packard (HPQ) (5% of the portfolio) is a case in point, as is the fund's heavy stake in financial-services stocks (36% of the portfolio as of Jan. 31, nearly double the large-cap value category average). Despite a strong first quarter of 2013 (up 13.8%), the fund lags its peers by an average of more than 2 percentage points per year during the trailing three-, five-, and 10-year periods. For this subpar performance, the fund charges investors 1.31% in annual fees for its class A shares and may also charge a load.

 Legg Mason Capital Management Opportunity (LMOPX)
Although the fund's 2012 and 2013 performances have been among the best in the mid-cap value category, they come on the heels of a disastrous 2011, in which it lost 35%. This volatility is par for the course for a fund that has landed in the bottom decile of its category in four of the past six calendar years and in the top decile the other two. Although the fund falls in the mid-cap value category, manager Bill Miller invests across the market-cap spectrum depending on where he sees opportunities. (Miller stepped down from  Legg Mason Capital Management Value Trust (LMVTX) last year but remains on board here.) At the end of 2012 the fund was overweight financials, tech, and consumer cyclical stocks while holding no basic materials, consumer defensive, or utilities stocks. The C shares, which make up the largest portion of fund assets, cost 2.08% in annual expenses.

 AllianceBernstein International Value (ABIAX)
Despite a management shakeup last year, this volatile foreign-value fund's approach remains the same, with managers looking for large-cap foreign stocks selling at steep discounts to management's estimates of the firms' intrinsic values. The portfolio's sector and country weightings usually are kept in line with the MSCI EAFE Index, though the fund currently is overweight in Japan and underweight in developed Europe. Morningstar attribution analysis has found that poor stock selection has been the main cause of the fund's poor performance. Fund assets, which stood at close to $6 billion at the end of 2007, now stand at less than $300 million. The fund's three-, five-, and 10-year trailing returns all land it among the worst 5% of performers in its category. Annual expenses are 1.41% (for class A shares), and the fund may also charge a load.

Performance data as of April 1.