The point of writing this article on the 3 worst mutual funds is not to pick on these funds but instead  to educate the investing public on ways to avoid investing in “bad” funds.

1) The Fairholme Fund (FAIRX)- this mutual fund has been a hot topic of late, manager Bruce Berkowitz did a fantastic Job over the last 10 years of crushing the S&P 500, the problem is that in order to do this Berkowitz had to consistently make concentrated sector bets, and unfortunately for investors in this fund this was the year where everything went wrong.

After being names Fund Manager of the Decade and Fund Manager of the year by Morningstar, the Fairholme Fund saw a huge increase in assets as well as the pressure to perform to meet these high expectations.

So Mr. Berkowitz took a huge bet this year on the recovery of the financial sector taking huge positions in Bank of America, Citigroup, AIG and St Joes. Obviously this was the wrong bet and the Fairholme Fund has lost more than 35% year to date vs a loss of 7% for the S&P 500.

This is a devestating loss of capital in a very short period of time, and has put the fund in the bottom of decile of virtually every mutual fund category. This is why almost $10 billion has poured out of this fund over the last year.

There are two lessons that investors can learn from Fairholme’s implosion, the first and most important past performance does not predict future performance, and there could not be a better example than this fund which crushed the competition for 10 years and then dropped a cliff this year; secondly make sure when a fund has a huge increase in assets that the fund has enough research staff or resources to deal with all the new money pouring in.

Fairholme has historically been a one man shop run by Bruce Berkowitz,  who obviously has been a very savvy stock picker, but other than him the funds literature tells very little about any other employees or research staff, so you have to begin wonder if one man can manage such a huge asset base.

2) Diamond Hill Long-Short (DHCFX) is a $1.8 billion dollar long-short equity based mutual fund run by Diamond Hill Capital Management out of Columbus, Ohio.  The big beef I have with this mutual fund is the cost, the Diamond Hill Long Short- Equity has a 1.00% load and a 2.56% expense ratio, which is an incredibly high for a mutual fund and well above the Long Short Category Average expense ratio of 2.05%. This means that over a course of a year investors will lose 3.56% of their principal no matter what the fund does.

 Moreover this fund has not performed very well over the last five years. The fund has trailed the S&P 500 over the last 3 year rolling period as well as the last 5 year rolling period. More importantly the fund underperformed the S&P 500 by more than 16% percentage points in 2010. That is an awful big underperformance especially when you are paying more than 3% to just invest in this fund.

Yet I will give the fund a lot of credit in terms of transparency the fund has a lot of information on the managers and its investment process, and they should get credit for being one of the first mutual funds in the Long-Short Equity Space.

The lesson to be learned from this mutual fund, is to always be very selective of mutual funds that have a high expense ratio, if the fund is not outperforming its index on a consistent basis by a wide margin than its proabaly better to be in an index fund or ETF.

3) Fidelity Magellan (FMAGX) – is on my list just due to its sheer size and number of investors who continue to stick with this fund even though its done about everything wrong in terms of performance. Magellan has basically trailed the S&P 500 over the last 1 year, 3 year, 5 year, 10 year and 15 year rolling periods. As terrible of performance as this is the good news is Fidelity just fired the current  Magellan manager and maybe this shakeup will give the fund a fresh start because at this point its performance cant get much worse.

The lesson to be learned from this fund is complacency with over $17 billion in assets under management obviously there are a lot of investors who have stuck with this fund, even though its performance has been terrible, just because a fund has a legendary name like Magellan or a big brand name like Fidelity does not guarantee it success.

Tommorrow I will give you the three best mutual funds that no one is investing in..

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