When to Make a Clean Break From Your Funds

Investing in a mutual fund is like entering a relationship. You should know your partner well; after all, you're going to be together during good times (bull markets) and bad (bear markets). And no matter how attached you get to your fund, sadly, sometimes you'll need a divorce. Consider a breakup if you find yourself in one of these situations.

Change of portfolio manager

You did your homework before you bought a fund, and you have faith in the fund's manager. But what happens when he or she departs?

This is often, but not always, a time to sell the fund. First, research the new manager's track record (if there is no track record, sell). If the manager has a long record running a similar fund with like performance, then you're in good shape.

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Occasionally, the new manager can fill the old one's shoes, if he or she has been schooled at the master's knee and groomed to take over. For example, when the legendary Michael Price retired, Mutual Series scarcely missed a beat because David Winters, his lieutenant, took charge. But more often, it's like Magellan Fund after the retirement of the great Peter Lynch in 1990: No one else has had the same success.

An important exception to this rule applies to funds run by a team or committee. For instance, the departure of one team member on a Dodge & Cox or American fund is less disruptive than a sole star manager stepping down.

Be wary if a fund family tells you a manager change makes no difference. Chances are the company originally sold the fund on the merits of the ace manager. They can't have it both ways.

Change in style

We'll divide this into two parts: the manager's style and your style.

In the first case, say you invested in a fund that bought midsize-company stocks, but the manager began drifting into large companies as his fund increased in size. That's exactly what happened with Calamos Growth. Or maybe you put money with a manager who claimed to be a patient value guy, but he began chasing frothy growth stocks and turning the portfolio over 100% a year. Those could be reasons to cut and run.

In the other case, you change. Perhaps your fund helped you reach your financial goals, but now you're approaching retirement. That aggressive-growth fund in your 401(k) no longer makes sense for you. You may want to shift to a more conservative fund that focuses on capital preservation and income.

Asset bloat

Too much money in a fund "is the enemy of great returns," asserts Steve Rogé, a financial adviser and manager of Rogé Partners. This is particularly true for small- and midsize-company funds. Because small-company stocks tend to be harder to buy and sell in large quantities, bloated funds may actually raise and lower small-company-stock prices as they buy and sell shares. That makes trading expensive. Super-heavyweight large-company funds could take a week or more to build or exit a stock position.

Rogé thinks small-company funds should close to new investors before their assets reach $1 billion. He says to be on the lookout for overweight small-company funds that start diversifying too much -- moving from 30 stock holdings in the portfolio to 100 stocks, for example. You want a manager's best investment ideas, not his marginal ones.

Increased fees

Because fees can be a big drag on returns, particularly in fixed-income funds, check them periodically. After mergers of fund families, you may find the new regime is tacking on fees. Or maybe a "fee waiver" ends and you discover that annual fees have quietly crept back up from 0.85% to 1.25%.

Stock overlap

You may think you're diversified, just because you own 20 funds. But often funds that invest in the same type of securities, such as big-company growth stocks, own many of the same names. So your portfolio may be too concentrated in certain stocks without your knowing it.

You don't need four funds that invest in the same thing -- one good fund in each category will do. Simplify your portfolio and your life by selling redundant funds.

To see how well diversified your portfolio really is (or isn't), "x-ray" your mutual funds. Morningstar Instant X-Ray can help you compare the holdings of funds in your portfolio.

Poor performance

We saved the most complicated and vexing situation for last. Too many investors sell a limping fund too quickly. Even the greatest fund managers have off years. It often just means they've stuck with their type of investments while the market temporarily favored other investments. If your fund's peers have outshone it over a one- or two-year period, that's not enough reason to ditch the fund.

Burt Greenwald, a financial planner in Philadelphia, suggests studying a fund's performance over three to five years before making a decision to sell. Most advisers will tell you to compare your fund's three-, five- or even ten-year performance against that of its peer benchmark (such as large-company value stocks) or index (for instance, Standard & Poor's 500-stock index). For example, if the average REIT fund returned 20% over five years but yours only generated a 5% to 10% return, it's time to part ways.

Another reason to sell

Rebalancing your portfolio is another reason to sell or trim fund holdings. A couple of factors could trigger rebalancing.

Say you have your portfolio just the way you want it, with a certain percentage in big-company stocks, foreign stocks, and so on. The portion in real estate stocks is 5%. Then your real estate investment trust fund soars, so REITs now make up 10% of your portfolio. It's time to realign your portfolio by taking some REIT money off the table and investing the proceeds in lagging sectors, to move your portfolio back into balance.

Rebalancing can be challenging. Your instinct is to let winners run, even as investments get overpriced, and to avoid moving money to investments that have performed poorly. But to control risk and improve your portfolio's performance in the long run, you need to rebalance.

Many financial advisers suggest rebalancing your portfolio annually. Others recommend simply waiting until allocations move five percentage points out of whack, as in the REIT example above.