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Which star fund manager turned it around in 2012?

(MoneyWatch) Most investors choose fund managers based on past performance. However, you never know if that manager will keep winning or see his luck run out. The following tale of two legendary managers shows the random nature of investment returns.

Not long ago, hedge fund manager John Paulson was hailed as a master of the universe. He famously generated returns of up to 600 percent by betting against mortgages in 2008. In 2011, Paulson's performance was also characterized as the "stuff that makes legends." Unfortunately, the sign was wrong. The Paulson Advantage Fund lost 36 percent, and the Paulson Advantage Plus Fund lost 52.5 percent.

For investors who believed that 2011 was just a temporary detour for Paulson, 2012 has provided a test of their patience. Through November, the Paulson Advantage Plus Fund had lost another 22 percent. His other flagship fund, the Paulson Advantage Fund, had lost 17 percent.

On the other hand, the performance of legendary investor Bruce Berkowitz and his Fairholme Fund (FAIRX) turned around in 2012. Berkowitz had earned Morningstar's title of manager of the decade. From 2004 through 2010, the fund never once ranked below the 23rd percentile in performance. Five times during that period it finished in the top 10 percent relative to its benchmark.

Of course, that type of performance leads to lots of cash flow from investors who did not earn those great returns. In 2011, FAIRX lost 32.4 percent, underperforming its benchmark by 31.7 percent and ending up near the bottom of the pack in performance.

The question for investors: Was 2011 just a bad year for Berkowitz? Fortunately for Fairholme's investors the fund has produced a dramatic turnaround in performance. Through December 3, the fund was up 29.1 percent and ranked in the top 1 percent of funds.

The problem is that there's no evidence that anyone can persistently pick which managers will rebound like Berkowitz or continue suffering like Paulson. Both had outstanding records followed by a lousy year. How would you know to choose one over the other?

The evidence from research on the persistence of performance of active managers has demonstrated that even long streaks don't have predictive value. Consider Bill Miller, the former Legg Mason Value Trust manager who beat the S&P 500 Index for 15 straight years, only to see his performance place him in the 98th percentile or worse four of the next six years.

That's why prudent investors don't bet on fund managers. Instead, they invest in low-cost, passively managed funds that deliver the return of the asset class to which they are seeking exposure.