COMMENTARY: DON'T JUST DUMP THAT FLAILING EQUITY FUND
Market volatility is up, you're nervous, and your equity fund is in the doghouse. Is it time to sell? This is one of the toughest investment decisions to make. But in the investment world, selling is often the best course of action. Before you cut and run, however, review your plans, in the context both of the fund itself and of your overall investment plan.
Sure, you may feel like bailing out when the market is sliding. But if you have a long-term investment objective and have carefully made an asset-allocation plan and selected your funds, daily or weekly market gyrations shouldn't be your No.1 consideration. And while it's natural to be frustrated with a fund that's losing value or even moving sideways, make sure it's the fund and not the market sector that's the problem. For example, if you currently own a small-capitalization aggressive-growth fund, chances are its performance has been flat. The entire small-cap growth sector, however, has had difficulty recently: Look at the decline of about 12% this year in the Russell 2000 index. If aggressive growth is really your objective, you might have to wait out the sector's underperformance.WRONG GUESS. If the sector you're investing in is moving higher but your particular fund is somehow being left behind, your fund manager may have made a major error. Consider the $6.5 billion Brandywine Fund, managed by the highly respected Foster Friess. In 1997, the fund produced a return of just 12%, while its peer group--large-cap blended funds--gained nearly 22%. Why the lag? Friess built up cash in his portfolio in anticipation of a correction. It didn't happen, and the fund suffered.
Be sure to check whether your fund posted average returns with above-average risk. After all, you don't want to own a fund that doesn't compensate you in return for excess risk when compared with similar funds in its peer group. But don't unload it in haste, either. If your fund, like Brandywine, has had a string of outstanding years and just one period where it lagged, don't dump it. Every manager will make mistakes, after all.
If your fund has delivered superior returns over several years, you should give the manager the benefit of the doubt. Call and inquire about the poor performance. If the manager has left and returns have dropped, it may indeed be time to sell. But if the manager and the strategy remain in place, think about sticking it out. There are no rules on how long you should stay with a fund that is underperforming, but consider giving it six months to a year to recover, compared with its peers.
If you've given it adequate time and your fund is still lagging in return and risk, it's time to take action. But make one last check of these items to make sure your fund is really a dog:
-- Review the fund's 1-, 3-, and 5-year total returns vs. its peer group.
-- Look at its standard deviation (the variability of a fund's returns) and beta (its sensitivity to changes in the overall market) against the fund's peer group. Also review the Sharpe ratio, a measure of risk-adjusted returns. It should be above 1.0. You can find such information at several investor Web sites, including S&P Personal Wealth (www.personalwealth.com) and Morningstar.Net (www.morningstar.net).
-- Examine your original investment plan to see if the fund's objective still matches your long-term investment goals.
And don't forget the tax angle. If you've owned a fund for many years, you may have built up big capital gains. When you sell the fund, you will end up paying taxes on those gains. Fortunately, the long-term capital-gains tax is now just 20% for holding periods of 12 months or longer, so the burden has been eased. Paying the tax, however, reduces the earnings power of your fund investment by at least 20%. If the fund is trailing its peers by only a small amount, it may not make sense to sell. But if your fund is in a tax-deferred retirement account such as a 401(k), the tax question is moot.
It's far easier to buy a fund than to sell one, because selling represents a realization of your monetary loss and an admission that you may have made a bad investment decision. But selling a fund without doing your homework could be just as big a mistake.By Chip Norton