When to Pull the Plug

It was an awful year, and your fund was down -- not merely as much as the market, but more than the market. Should you fire your manager? Your gut says yes, but guts aren't especially good investors. They don't know that every fund will lag its benchmark from time to time. So it's best to approach the dump-or-keep decision coolly and methodically.

Let's start with the raw-return figures. To use them properly, you must have the right context. Begin by asking whether your fund was expected to outperform in down markets or in up markets, or when either growth or value investing is fashionable. Given those expectations, how did the fund do?

The cash factor. Keep your expectations realistic. In the bear market, virtually every stock fund that stayed fully invested lost a bundle. You can't rationally penalize a stock fund for that. If you want a fund that will make timely moves to cash, look for indications in its prospectus and in its track record that this is something the fund might choose to do. If the prospectus says the fund will always have at least 80% of its assets in stocks, or if the record shows that it rarely holds a big cash stake, it's not reasonable to expect that the manager would ignore the prospectus, chuck aside his strategy and move into cash.

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But what if your fund really did do poorly relative to realistic expectations? Then you should look at the manager's whole body of work. Was the past year an aberration or one in a long string of poor results? For example, Third Avenue Value (symbol TAVFX), Dodge & Cox Stock (DODGX) and Janus Worldwide (JAWWX) performed miserably over the past year. But Dodge & Cox and Third Avenue still boast strong long-term records. By contrast, Janus Worldwide has lagged its global-stock peer group in every calendar year since Jason Yee assumed the mana-gerial reins in July 2004.

In my view, the managers at Third Avenue and Dodge & Cox are still excellent investors. They just happen to have blown it last year. Yee's performance, though, was the final straw, taking Janus Worldwide from mediocre to crummy. Janus must have felt the same way, as it recently replaced Yee with Laurent Saltiel, whose two-year record at another Janus fund is decent but too short to be meaningful.

Beyond examining results, try to determine whether any fund-specific developments could affect perform-ance. Have key managers or analysts left? Has the fund shifted its strategy? Have there been other fundamental changes? (You can get this information from Morningstar reports or at a fund's Web site, although you may have to do some digging.)

With Dodge & Cox and Third Avenue, the answer to all those questions is no. I've seen both firms perform poorly for periods because their style of investing was out of favor. But they stuck to their strategies and continued to build up their staff of managers and analysts.

Western Asset Core Bond (WATFX), however, is a different story. The fund got burned last year by holding hefty stakes of nongovernment mortgage-backed securities, as well as corporate bonds from the likes of Lehman Brothers and three Icelandic banks. Plus, Western Asset, a unit of Legg Mason, has seen some changes in personnel and is retooling its approach to risk management in light of the missteps. You generally don't want to own a fund when the "under construction" sign is up. In addition, heavy redemptions in the firm's mutual funds and separate accounts have made a bad situation worse by forcing managers to sell bonds at unfavorable prices. As a result, we recently removed the fund from our Analyst Picks list.

It's natural to want to punish your poor performers. But if you're not careful, you may punish yourself. Every good fund suffers through periods of subpar perform-ance. If you dump a good fund because of one or two mediocre years, you're likely to miss out on future periods of superior performance.

Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.