The Difficulty in Picking Mutual Fund Outperformers

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Investing God Bruce Berkowitz. Battling His Own Success?About two years ago, I made a bet with a senior writer of this magazine, suggesting that he NOT buy shares of the Fairholme Fund, run by Bruce Berkowitz. You'll recall that Morningstar named Bruce Berkowitz the "Fund Manager of the Decade" for his unbelievable performance in the 2000s. Is his recent slump a mere hiccup? Or is this another lesson in why one should never chase the hot dot and why one should never follow Morningstar star ratings? What do you think?

My point to my colleague was when a manager gets so popular, when money pours in, when he is featured in the popular financial press, well, it may be time to take a pass. We all know what size does to a fund. I am not suggesting that Berkowitz might have lost his talent. After all, he takes concentrated, contrarian bets in multicaps. For example, 10 stocks, many of them financials, comprise more than 50% of his holdings (27% is in cash). Over the past 10 years, FYI, FAIRX beat 96% of its peers, says Morningstar.

Right now perhaps his style is just out of favor (well, financials certainly are; depending on what you think the impact of Dodd-Frank and Basel III will have on ROE of financial institutions, you may have to think carefully before investing). And perhaps now might be the time to buy --- or soon. Brad Hintz, the senior analyst at Bernstein Research, points out that Wall Street "shoots its wounded" and "eats its young" and is very adept at reclaiming high margins and ROE.

But it might be painful for a while. As the New York Post reported over the weekend, shareholders have yanked out $3.5 billion over the past four months, "with $1 billion last month alone." The Post continues, the $19.27 billion fund is down by 9% year-to-date while the S&P is up around 7%.

My question to you, Dear Reader: How to pick mutual funds? Do you buy a dog that was once great? Or do you chase momentum? Or just buy the market via various ETFs and go home? There is a ton of literature on this stuff. If anyone knows of a solid insight, please pass along.

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