3 Mutual Funds to Steer Clear Of

Rob Silverblatt

Long-term investors are often loath to part with their mutual funds. Still, there are plenty of problem-plagued funds, and in many cases it's downright difficult to make a case for them.

With that in mind, here's a list of the three worst-rated funds as determined by U.S. News's Mutual Fund Score. The U.S. News rating system takes into consideration long- and short-term performance, risk, expenses, and future prospects. It does so by combining fund opinion from Morningstar, Zacks, Lipper, TheStreet.com, and Standard & Poor's. Only those funds that are evaluated by all five of these sources are scored by U.S. News. Scores are normalized to a 10-point scale, with 1 being the worst and 10 the best.

All told, U.S. News has scored upward of 4,500 distinct funds. For the purposes of this article, funds that are not scored have been screened out, as have those that have less than $100 million in assets under management. Funds whose primary purpose is to employ leverage to magnify the returns of an index have also been excluded.

Manning & Napier Small Cap (U.S. News Score: 2.1). After cobbling together some strong returns in 2005 and 2006, this fund fell flat. Its 50.7 percent loss in 2008 was particularly painful. The fund bounced back last year, but plenty of concerns linger. As Morningstar analyst Michael Breen puts it in his latest report on the fund: "This fund has all the pieces of the puzzle but hasn't put them together. It has improved lately but needs an extended winning streak to dig out from the hole it dug itself a few years back. Investors are right to wait until the fund proves it can pull things together permanently before jumping in."

Oppenheimer Champion Income (U.S. News Score: 2.1). This high-yield bond fund has seen the worst of both worlds recently. Amid a crushing 78.5 percent loss in 2008, Oppenheimer Champion Income pruned its portfolio. That move backfired last year when junk bonds had a blistering rally, which this fund failed to capitalize on. Over the trailing three-, five-, and 10-year periods, this fund lags behind 99 percent of its peers in Morningstar's high-yield bond category.

Invesco Van Kampen Limited Duration (U.S. News Score: 2.6). This fund has underperformed in all kinds of environments. Notably, with the exception of 2005, it has finished every year of the 2000s in the bottom half of Morningstar's short-term bond category. Over the trailing three-year period, its returns are 10.7 percentage points less than those of the Barclays Capital U.S. Aggregate Bond Index. In the bond world, that's quite the stunning differential.

While these funds have all suffered from dismal performance, bad returns aren't the only reason to dump an investment. Here are some other factors to consider:

Be mindful of management changes.

A sudden shake-up in management is generally enough to raise concerns among watchful investors. That's particularly true when a popular manager leaves. For instance, when TCW fired star manager Jeffrey Gundlach late last year, investors retaliated by pulling billions of dollars out of the firm's flagship Total Return fund. These sudden outflows prompted questions about the fund's stability.

Picking the right manager is, of course, vitally important.

"The name of the fund doesn't matter," says Adam Bold, the founder of the Mutual Fund Store, an investment management firm. "What counts are the people who are every day making the buy, sell, and hold decisions."

That's not to say you should necessarily follow your manager out the door whenever changes occur. First, take a look at the new management and see if the team's strategy still aligns with your investing goals. "Human nature being what it is, a manager that takes over a portfolio is going to want to make a mark," says John Bonnanzio, the editor of the newsletter Fidelity Insight.

Be wary of unsustainable returns.

Sometimes, the funds that grow the fastest are the ones that fall the hardest. If your fund is experiencing uncharacteristically high returns that don't look sustainable, having the discipline to take your winnings and run is a must. "People tend not to sell funds when they're moving higher, and all too often they fall off the cliff with them," says Bonnanzio.

Take Fidelity's Spartan Long-Term Treasury Index. Bonnanzio's newsletter downgraded the fund in late 2008 after the treasuries market started to lose its appeal. As it turns out, his timing was just right. After surging by 24 percent during the market turmoil of 2008, the fund lost 13 percent last year. "The market is very good at sending signals about things that are either overbought or oversold," Bonnanzio says. It's just up to you to listen.

Don't pay more than you need to.

Mutual funds' annual fees -- or expense ratios -- are tricky to evaluate. If a fund can consistently deliver superior results, it may be worth shelling out a bit more in fees. But if your expense ratio is high to begin with, or if your fund provider decides to hike fees, it should at least raise a red flag.

Notably, quality funds often see hefty inflows, and this allows them to keep their overall fees in check since each investor has to pay a smaller portion of the various fixed expenses. Meanwhile, if a fund increases its expense ratio, it can be an indicator of institutional difficulties that may have a downstream impact on performance.

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