Doing some spring cleaning in a mutual-fund portfolio sounds smart. But it’s a lot tougher to do–or at least do well–than washing the bedroom curtains.
While everyone would like to dump the perennial laggards and hopeless has-beens in his or her portfolio, such “dogs” aren’t always easy to find: A fund may be doing poorly because the manager’s style or the asset category is temporarily out of favor, for instance. In that case, the smarter move may be to hold on or even invest more money at a low price.
Investment professionals disagree on how long a dry spell to endure before selling a previously strong fund.
When fund shares are held in a taxable account, moreover, there are tax complications to weigh. Selling a long-held position can entail a big taxable gain. And that tax hit could prove particularly painful if the portfolio shift seems unnecessary or even misguided by the time the next tax-filing season rolls around.
Deciding to sell a fund is “a tougher call than buying,” says Roy Weitz, a California accountant and investment manager whose FundAlarm site on the Internet provides fund-selling guidance.
At The Wall Street Journal’s request, Weitz and Russel Kinnel, director of stock-fund research at Morningstar in Chicago, each compiled a list of 10 “sell” candidates. They were asked to focus on big funds investing in U.S. stocks.
Additional sell suggestions were included by newsletter editor Doug Fabian, who is working to incorporate more portfolio-pruning advice into his Fabian Premium Investment Resource, Huntington Beach, Calif.
Investors “need leadership to let go of underperforming funds,” Fabian says. Well, maybe. But a review of Fabian’s sell candidates and, to a lesser extent, Weitz’s Web site (www.fundalarm.com) also suggest the hazards of a cursory approach to portfolio cleaning.
To wit: Four of the funds that Fabian identifies as serious underperformers among “growth” funds–AIM Constellation Fund, Oppenheimer Discovery Fund, T. Rowe Price Capital Appreciation Fund and Yacktman Fund–are funds that Morningstar rates as average or above-average performers according to its criteria. Morningstar divides funds into narrowly defined peer groups based on the kinds of securities the funds have held in recent years. In addition to a fund’s historical return, the Morningstar ratings consider the amount of risk a fund has taken along the way.
Those four funds “look like funds that are being punished (in the Fabian analysis) because they are miscategorized or paying more attention to risk,” Morningstar’s Kinnel says. Fabian stands by his sell suggestions and says Morningstar analysts “rarely come out with any sort of rules or opinions about when it is time to sell a fund.”
In considering any lagging fund in one’s portfolio, Mark Riepe, head of fund research at Charles Schwab, says the first question to ask is this: Is it the fund or the broader asset category that is the problem? Gold funds and Asian-stock funds are two categories that have saddled investors with big losses over the past year, for instance. Investors tempted to bail out of such funds need to review why they invested in the first place–and decide whether they still want to be in those sectors going forward.
Gold funds, once widely touted as inflation hedges, aren’t recommended by many investment advisers these days. But many advisers remain enthusiastic about investing in the “emerging” economies of Asia, Latin America and Eastern Europe. “Long term, there is a lot of opportunity, and you will be rewarded for the risk that you take,” Andrew Mehalko, director of research at DCA Global Investment Management in Ft. Lauderdale, has been telling clients tempted to bail out of Montgomery Emerging Markets Fund.
Closer to home, the issue for U.S. stock funds isn’t usually losses, but more often disappointing gains. One of the trickiest questions in looking at disappointing funds, though–as the disagreement among the fund watchers makes clear–is ascertaining whether they are really lagging at all. The challenge is to identify a reasonable peer group or benchmark against which to measure a fund’s performance.
Consider a hypothetical stock fund that returned 15 percent last year. That fund certainly looked terrible compared with the 33 percent advance in Standard & Poor’s 500-stock index, probably the most widely cited yardstick for U.S. stock funds. But lots of stock funds lagged far behind the S&P 500 simply because they aren’t as concentrated as the index in a small group of giant stocks. And if this particular fund specializes in small, fast-growing companies, it actually beat the 14.4 percent return of the average “small-growth” fund tracked by Morningstar.
“You have to appreciate the fact that different styles, market capitalizations and sectors go in and out of favor,” Kinnel says. “If a fund is doing well for its style, then it might well be a good holding for the long term and it might have strong returns later on.” Morningstar divides diversified U.S. stock funds into nine style categories that, over the past decade, have ended up delivering very similar results.
A perusal of Weitz’s FundAlarm Web site highlights how tricky assessing funds can be. Weitz assigns “three-alarm” status–indicating strong candidates for sale–to funds that lag behind a benchmark over the past one year, three years and five years. Unfortunately, the current list of more than 370 three-alarm funds includes some for which the selected benchmark isn’t a good fit (such as the unusual ultralow-risk Merger Fund, which invests in publicly announced mergers, compared with an ordinary stock index).
There are also many funds that have gotten new managers in the past year. Investors may want to wait a while to see if the new chiefs can turn things around. (The FundAlarm Web site lists fund-manager changes separately.)
Also on the three-alarm list: funds such as Putnam Fund for Growth & Income and T. Rowe Price Equity-Income Fund that have delivered solid returns with limited risk, while admittedly trailing a tough benchmark, an index fund mirroring the S&P 500. eitz says one Web-site visitor accused him of being “greedy.
There are several factors besides performance and risk that investors should consider in considering lagging funds. One is fund size. For funds that specialize in small stocks, assets exceeding $1 billion or so can prove balky. Another is annual expenses. Kinnel and Fabian cite high expenses as a reason for some of their fund-sale suggestions.
There is also a broader question of whether a fund makes sense to begin with. Kinnel advises selling Florida municipal-bond funds, for instance, because he says their low yields make them a poor investment even for Florida residents subject to the state’s intangibles tax. And he dislikes overly narrow “gimmick funds,” which in his mind include funds investing in companies in a single city or a single business, such as sports.
One of the most vexing questions for fund investors is how long to hang on to once-stellar funds that are going through a tough spell relative to their peers. Kinnel says he would sit through at least three years of underperformance “if I thought they were still doing what made them successful in the past.” He points to Mario Gabelli as a time-tested manager whose funds shined in 1997 after two years of sluggish performance.
