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Knowing When To Dump A Mutual Fund


Personal Business: INVESTING

KNOWING WHEN TO DUMP A MUTUAL FUND

The tiny $57 million Monetta small-company fund topped the charts with a 55.90% return in 1991, beating the Standard & Poor's 500-stock index by more than 25 percentage points. Not surprisingly, the money came pouring in, and the fund's assets ballooned to $524 million by 1993. But Monetta's stellar performance was achieved by deftly managing a small asset base, not a large one. So the fund has trailed the index an average of seven percentage points for each of the past four years. It has even fallen behind its peers--with a three-year annualized return of 12.89%, compared with 19.49% for the average small-cap fund. Time to dump Monetta? In short, yes. While small-cap stock funds are enjoying strong returns this year, Monetta again is no star.

Consistently poor performance is the most compelling reason to leave a fund. But it's important "to analyze the situation to explain why a fund is doing badly before you dump it," advises Sheldon Jacobs, editor of No-Load Fund Investor. There may be good cause for sagging returns. Maybe the particular sector your fund invests in is currently out of favor, or maybe there has been a change in portfolio manager. That doesn't mean you should hold on--but at least you can then make an informed decision.

One explanation for a slump might be a rapidly growing asset base, especially in micro or small-cap funds. That's what happened in Monetta's case. A $100 million fund can take 5% of its assets and move in and out of a small company without controlling too many shares or pushing up stock price. But when a fund swells to $1 billion, putting 5% of its assets in a small company is likely to increase the share price--and the cost to the fund--or it may leave the fund with a large holding that's difficult to unload. Result? The manager has to buy larger companies or many small ones. "A fund loses a lot of flexibility" when its assets grow quickly, says Ken Gregory, editor of No-Load Fund Analyst. Then the returns start to suffer.

FASHION. It's also possible that your manager's investing style could find itself out of favor. Sometimes, growth stocks, whose focus is on earnings increases, are in vogue. At other times, value stocks, which have low price-earnings ratios, pull in the high returns. To be sure, neither style stays hot forever. What's important is to avoid selling a laggard fund simply because the manager's style or specialty, such as gold or natural resources, happens to be unpopular during the time you're analyzing its performance. Michael Price of the Mutual Series funds, for example, is a die-hard value investor. Price's funds fell to the bottom of the heap when growth investing was all the rage in 1989 and 1990. But when the value stocks took off in 1992 and 1993, so did Price. He has continued to do well. Through April of this year, the four funds that he manages have all topped the S&P 500's gain of 6.92%.

To avoid making a premature sale, compare the fund's returns with the appropriate index, such as the S&P superscript500, the Russell 2000, or the Morgan Stanley Capital International index. Weigh them also against other funds that have similar styles of investing. If your fund is in an ailing-asset class but still is doing better than its peers are, you may want to hold on. "Stock-pickers have good years and bad years. But start asking questions about a fund with two years of underperformance relative to its peers and the market," says Gregory.

If the sector hasn't been unpopular, consider selling a fund if it has lagged behind the appropriate index for three years in a row. Make sure you evaluate the fund over time and not just the years during which you owned it. One fund that recently fell into this underperforming category with a headline-making bang is Fidelity's Magellan. For the three years ended Apr. 30, this $56 billion flagship fund trailed the S&P superscript500: The gains were, respectively, 16.08% and 17.20%. While Magellan has returned more than the 13.30% of its large-cap peers over the same period, an investor must nevertheless consider the risk taken to turn in such a performance. The fund's huge size necessitates that manager Jeffrey Vinik make higher-risk, market-timing bets. Given that uncertain strategy, it's unlikely Magellan will be topping the charts as it once did.

DANGER SIGNALS. Just as three years of patience may be needed with a good fund gone bad, wait out the urge to jump ship immediately when a star manager leaves. It takes about six months for a new recruit to clean out the predecessor's portfolio. So slumping returns aren't likely to start showing up until a year or so after the change at the helm. How long you give new managers depends on their past performance: If it's solid, wait a year or two. Leave sooner if the track record is spotty. Shareholders in Vanguard's Windsor fund, for example, would do well to stay put despite the departure of veteran manager Jeff Neff, who retired in December after a 31-year reign. Neff's replacement is Charles Freeman, who had 25 years of experience by Neff's side. He is likely to manage the portfolio in much the same way his predecessor did.

Also beware of managers who wander from the fund's mission stated in the annual report or in its prospectus. Whether the change is in risk level or in investing style--say, from value to growth stocks--the alteration could be a signal to sell. Why? The balance in your portfolio can be upset, especially if you choose each fund for a specific style or strategy. In effect, meandering managers are not doing what you hired them to do.

Both Vista Capital Growth A and Vista Growth & Income A seem to have strayed from their original investment style, according to Mark Bell of Mark Bell & Associates, a money-management firm in Chicago. The Capital Growth fund started with a small-cap growth portfolio and has drifted to medium-cap value, while Growth & Income has become a large-cap value from a small-cap growth strategy. Both funds have trailed the Ssuperscript&P superscript500 for the past three years through Apr. 30. David Klassen, who manages both Vista funds, agrees that the market caps have gone up but so has the capitalization of the market as a whole. "We go to where the attractive stocks are," he says.

Sometimes your decision about selling a fund has nothing to do with its performance but depends upon other factors, such as a change in your personal circumstances. Say your last child finishes college and you no longer need an aggressive growth fund to foot school bills. Chances are you would rather have a more conservative investment as you approach retirement. Or perhaps you feel you can no longer stomach the volatility of an international stock fund. Any change in your investment goals is a good time to evaluate a sale.

HARD CHOICE. Mounting expenses should also raise a red flag. A fund that suffers lots of redemptions spreads its expenses over fewer shareholders. That increases costs and thus eats into your profits. You might want to cash in for a lower-cost fund if the expense ratio jumps to more than 1.50% of assets annually for a domestic equity fund, 1.85% for an international stock fund, or 1.00% for a bond fund.

Another cost to consider, and probably the most important for a longtime fundholder, is the capital-gains tax. Remember that you'll pay up to 28% of any profits you have in the fund when you sell it. Even if you switched into a better-performing fund, capital-gains taxes plus any back-end fees and future transaction costs for a new purchase are expensive and could leave you with less money in the long run. If you decide to sell, try to dump your shares before the fund company does its next capital-gains distribution, advises Bell. That way you won't be hit with a bigger tax bite.

Clearly, there is more to consider when selling than when buying a fund. But if you watch your portfolio closely, you don't have to be one of the longtime losers in a laggard.EDITED BY AMY DUNKIN Toddi GutnerReturn to top


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