Should You Dump Your Mutual Fund?
Just because you've lost a bundle isn't reason enough to pull the plug.
"I can't believe this is happening to me."
Unless you've avoided opening your mail the past few months, you've probably muttered those words at some point recently while staring at your mutual fund statement. But happening it surely is, and the magnitude of the losses in some of your mutual funds may be prompting you to think about jumping ship.
Judging when to hold a fund and when to fold can be devilishly tough business at any time. But it's especially difficult now that almost all investing markets have imploded. "U.S. stocks, international stocks, most bonds and commodities haven't worked, so there's really been nowhere for managers to hide," says Adam Bold, chief investment officer of the Mutual Fund Store, an investment advisory firm based in Overland Park, Kan.
For that reason, nine times out of ten your best course of action is to do nothing. If your chosen funds are part of a comprehensive plan for your money and you had confidence in their investment approach when you selected them, then you should probably sit tight and trust the decisions you made in less emotional times.
A down market has a way of illuminating a fund's weaknesses, which in good times can go unnoticed. If a fund's shortcomings are starting to come into focus, it might be time to sell your shares, harvest any tax losses and move on to better ideas. Here are four reasons to consider giving your flagging funds the heave-ho.
The easy call. The current bear market may be forcing you to rethink the basic issues of time horizon and risk tolerance -- key factors that determine how you spread your assets. You shouldn't overturn your asset allocation unless you've thought seriously about the consequences. But if you're losing sleep worrying that you're at risk for large additional losses, you should sell some of your stock funds.
Which ones? Start with the riskiest. Maybe emerging-markets funds, which on average lost 60% in 2008 through December 5, aren't for you after all. Besides, any diversified overseas stock funds you hold probably have some exposure to developing markets.
Egregious performance. The decision becomes tougher if you're not giving your portfolio an all-out face-lift. How do you measure incompetence or even mediocrity when nearly all the results across the investment landscape are miser-able? Fund managers aren't miracle workers, and with virtually every kind of stock performing poorly, they've discovered that sometimes nothing works.
This differs markedly from the 2000Ð02 bear market, when most of the pain occurred among large-company and technology stocks.Put your fund's perform-ance in context by sizing it up against its peers. You can do this free on Morningstar.com by entering your fund's symbol and then clicking on "Total Returns." Returns over three-, five- and ten-year periods are useful but can easily be distorted by one unusually bad or unusually good year. Reviewing individual calendar-year returns is a better way of assessing a fund's performance.
The best funds beat their peers -- and their benchmarks -- year after year, in good times and in bad (although such singular funds can be hard to find). Otherwise, look for a pattern of more-conservative funds that lag their peers in good years, such as 2003 to 2006, but do better than average in down years, such as 2008.
"I would be very concerned with large losses coming from funds that were considered conservative," says Jeff Bogue, a Maine financial planner. Similarly, racier funds get a pass for losing more than average during the bear market, as long as they deliver superior performance in up markets.
For example, Loomis Sayles Bond, a Kiplinger 25 member, performed poorly in 2008 (down 28% through December 5). But the fund consistently landed in the top 10% to 15% of its category in each year from 2002 to 2007, and long term it still beats most of its peers. And although some of its managers' decisions -- such as loading up on corporate bonds too soon and largely avoiding Treasuries -- magnified losses in 2008, those moves will benefit shareholders once the bond market returns to some semblance of normality.
Clearly, Loomis Sayles Bond is more aggressive than the garden-variety bond fund. If you expect something tamer from a bond fund, you should probably sell. But if you can withstand the volatility, hang on for the inevitable comeback.
Also, consider whether a fund is filling its role in your portfolio. One category that has flopped miserably during the bear market is long-short funds. These funds sell stocks short, a strategy for betting on falling prices, and own other stocks the usual way. The end result is supposed to be a portfolio that thrives, or at least delivers respectable returns in good times and in bad. On average, though, long-short funds lost 18% in 2008 through December 5. A lot of these funds deserve to get the boot.
Gross errors of judgment. Many managers have fallen into this pit. The problem is, there's an ocean of gray between those who got it a little wrong and those who got it unpardonably wrong. "Even the best money managers did not see the magnitude of the problems staring us in the face," says Stephen Lukan, a Columbus, Ohio, financial planner.
When bad judgment becomes chronic, the call to sell is clear. For example, we removed Legg Mason Opportunity from the Kiplinger 25 in 2008 because manager Bill Miller made a string of bad calls -- among them his purchases of Bear Stearns, Countrywide Financial and Freddie Mac -- and shook our faith in his judgment (see "A Disastrous Year for the Kip 25," Jan.).
Smoking out the rogues from your portfolio will take some legwork. Use your favorite search engine to find articles about your funds, and check Morningstar.com and, of course, the Kiplinger.com archives for commentary. After that, you'll have to get your hands dirty. Go to the fund company's Web site and download all the manager commentaries and portfolio data you can find for the past two years.
As you comb through all that soporific verbiage and data, try to get a sense of whether the fund manager was taking the risks of the financial crisis seriously and whether he or she made any foolhardy bets. Did the manager build up an oversize stake in energy stocks or financials by June 2008? That would look pretty incriminating. (Some fund managers fess up to their foibles in shareholder reports and other missives, but we consider such forthrightness to be a plus.) Be sure to compare a fund's sector allocations to a relevant benchmark, such as Standard & Poor's 500-stock index or the Russell 2000 index.
Adding insult to injury. If you're still on the fence about a fund, look for one simple number to tip the scales: your fund's expense ratio. After all, what you pay for your investments is one of the few things you have control over. "Investors can't control what the market does or whether a mutual fund manager makes winning bets," says Dylan Ross, a New Jersey financial planner. "But all else being equal, lower expenses will result in a higher net return."
An annual expense ratio of 0.52%, unusually low for an actively managed fund, certainly helped to sway our opinion in favor of keeping Dodge & Cox Stock in the Kiplinger 25, despite a series of bad stock picks that cast doubt on its management's judgment (see What Went Wrong at Dodge & Cox).
Not surprisingly, some funds with the lowest expense ratios have beaten most of their peers during the bear market. Vanguard 500 Index, which tracks the S&P 500 and charges just 0.15% a year, bested two-thirds of similar funds in 2008 through December 5. And Vanguard Total Bond Market Index, which charges 0.19%, topped 88% of its peers.
Geared up to pull the plug? Don't hit the "sell" button until you've come up with a plan for the cash you'll be redeeming. As New York financial planner John Deyeso says, "One of the single largest mistakes investors make is they sell, leave the proceeds in money-market accounts, and the money just sits there."