A few words of guidance as you look through this year’s Guide to the Top Mutual Funds: Don’t be quick to fire your fund manager. Last year was a tough one to be a stock and bond picker. Most of the indexes tracked for this guide performed worse in 2015 than they did in 2014. The returns for many fund categories were also disappointing.

The only categories with higher average returns in 2015 than in 2014 were foreign stock funds and contra stock funds. Funds in the latter category are designed to profit when stock prices fall. Every other category tracked for this guide fared worse last year than in the prior year, including balanced funds, target date funds and bond funds.

To the extent that mutual fund objectives restrict their managers as to what they can invest in, fund performance is going to lag when their asset class or investing style does. This is why it’s important to compare similar types of funds. In our guide, we group funds by category. For stock funds, we note whether the manager follows a growth or value orientation and whether or not the fund follows a passive strategy (meaning it is an index fund). Bond funds are grouped by type (e.g., corporate, government, etc.) and duration (short-, intermediate- or long-term). This will assist you in making apples-to-apples comparisons.

It’s also helpful to realize that over any given period of time, some investing styles will be in favor and some will be out of favor. The U.S. markets provided a good example of this last year. The S&P 500 Growth index gained 5.5%, whereas S&P 500 Value fell by 3.1%. (The two indexes separate the S&P 500 into growth and value buckets.) Similarly, the large-cap S&P 500 gained 1.4%, while the S&P SmallCap 600 lost 2.0% and the Russell 2000 fell by 4.4%. Even among large-cap stocks disparity existed, with shares of the largest companies as measured by market capitalization faring better than their comparatively smaller-sized large-cap brethren.

In very simple terms, large-cap growth was in, while small-cap value was out. Depending on its objective and strategy, a fund either did better than average or worse than average—often through no fault of its manager.

Nonetheless, there are legitimate reasons to fire a fund manager. One reason would be several years of underperformance relative to the fund’s category peers. Another would be expenses that are above the category average and/or not justified by the performance.

Shareholders of junk (“high yield,” as the financial industry prefers to call them) bond funds would be wise to look at what their managers are investing in. Last December, Third Avenue Focused Credit fund (TFCIX) announced its intention to halt redemptions in order to conduct an orderly liquidation. The fund’s managers had made big bets on the debt of distressed companies. Though junk bonds can provide higher income, they are called “junk” because the issuing companies have weak financials. The managers of Third Avenue Focused Credit had invested in the riskiest parts of the junk bond market and were caught holding assets they could not easily sell.

It’s a possibility, not a certainty, that other junk bond funds might also encounter problems. You can get an idea of how risky a bond fund is by visiting its website, finding the list of assets and seeing what the exposure is to bonds with low credit ratings or no credit rating. According to Barron’s, Third Avenue Focused Credit held 28% of its portfolio in bonds rated CCC as well as unrated debt. (Not all unrated bonds are bad, but the lack of a rating should raise eyebrows.) Any bond rated Caa/CCC or worse (Ca, CC, C or D) is extremely risky. It’s also worth noting that the banks are starting to see an increase in bad debt among their loans to energy companies.

A little bit of effort now in terms of reviewing your funds’ holdings and strategies might prevent a potential headache in the future.

Wishing you prosperity,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII