With the whipsaw patterns U.S. stocks have experienced in recent weeks - both the Dow Jones Industrial Average and Standard & Poor's 500 Index are down 12% from their highs for the year - even the most ardent buy-and-hold investors are studying their portfolios, searching for holdings to cull.
But what if your buy-and-hold strategy has been implemented using mutual funds? As part of a solid "defensive-investing" review, should you consider bailing out of your current mutual-fund holdings at this point and start looking for better funds to ride into any future recovery?
You'll only know if you take the time to make the review. And you should take that time.
[mm-toolbar]Unfortunately, when it comes to mutual funds, the decision to switch horses isn't quite as clear-cut as it is with individual stocks, which are frequently dumped solely on the basis of adverse price movements. While poor performance - especially over an extended period of time - is usually the most compelling reason to abandon a mutual fund, other factors can also have a major impact on your decision.
In this two-part series - the first part appears today - we'll examine the eight questions to ask yourself as you attempt to determine whether your mutual fund still fits you - or whether it's time to move in another direction. Part II - and the remaining questions on that list of eight - appears tomorrow (Tuesday).
Here are the questions mutual-fund investors need to ask:
If any of this sounds familiar - and relates to the fund you're currently disappointed with - take a closer look at the fund once you review the remaining seven questions. You may find that the problem is related more to you, to your unrealistic expectations, or to the poor timing of your purchase, than it is to the fund. For funds you haven't owned for long, take the time to look back and review the fund's record for several years before you bought it.
If the fund has a strong historical record, and its other fundamentals are decent, it's probably worth ignoring recent poor performance - especially given the present market climate. It may also be a case of the fund's investing "style" being out of synch with current conditions (the examination of the years before you owned it will help you determine this). Consider holding on for at least a couple more years in anticipation of the next market or sector upturn, or for a resurgence of the fund's strategy (value, growth, momentum, etc.).
This is supported by a recent study conducted by Matthew R. Rice and Geoffrey Strotman of the Chicago advisory firm DiMeo Schneider & Associates LLC, which concluded that investors should hold their weakest funds for at least three years before bailing out. The researchers came to this conclusion after examining all the funds that finished in the top quarter of their Morningstar (Nasdaq: MORN) categories for the 10-year period ending Dec. 31, 2009. They found that, before moving to the top, 85% of those funds had at least one three-year stretch in which their performance ranked in the bottom 50% of their respective category.
"Even the best investment managers have periods of poor performance," the study's authors advised. "So you need to have patience when investing in actively managed funds and give them time to return to their superior longer-term performance levels."
In other words, it's the relative - not absolute - performance that matters here. Most investors buy funds to fill particular slots in a diversified portfolio (for instance, purchasing a large-capitalization fund to serve as a core holding; a small-cap fund to provide growth; a high-tech fund to add some speculative/big-bang potential; a metals fund to serve as a "hedge," and so on).
With that in mind, it's clear that your fund's performance should be judged in relation to its role in your portfolio and against other funds of its type and class. Comparing funds in different classes (growth vs. value, or small-cap vs. big-cap), and doing so in isolation, isn't going to give you the information that you need to make an informed decision.
For example, if the S&P 500 is down 15% over a given period and your large-cap fund is down only 12%, you're actually ahead of the game. Don't even consider selling. But, if the average return for funds in the large-cap category has been 12% over the past three years and your fund has recently gone from beating that average to badly lagging it, you probably have cause for concern.
Some analysts even caution against comparing the performance of a specialized "sector fund" with that of the general market, noting that very few market sectors correlate perfectly with the broader indexes. At the same time, however, you can't ignore major market moves like the 2008-2009 collapse or the sell-off from the late-April market highs, which dragged down nearly all funds, regardless of the sector.
Whether the market's weak or not, you should evaluate the performances of your funds over a longer period than you might an individual stock. Six-month or one-year returns aren't terribly significant in a long-term portfolio that is based on a well-conceived allocation plan. Short-term weakness could just be a sign that the particular sector in which a fund invests is currently out of favor, with the weakness being offset by another fund in your portfolio targeting a stronger sector - a condition that might reverse as economic conditions change.
Viewed in the perspective of your entire portfolio, three-year and five-year performance trends are better gauges of a mutual fund's merit. This is especially true given that the sheer asset size most mutual funds have achieved means that it they typically cannot rebound as quickly as an individual stock: Think of it in terms of a giant cruise liner versus a small speedboat - the speedboat can turn around and accelerate back up to top speed much more quickly than the cruise liner. That's another reason many analysts advise waiting for two or even three years - before you jump ship - to see if a lagging mutual fund can improve its performance.
Of course, if one of your funds suddenly begins to show weaker relative performance, this focus on the long term shouldn't preclude you from taking the time to figure out exactly "why" one of your funds is suddenly doing poorly. Here are four of the most common reasons a fund's performance can suddenly change - often for the worse; consider them warning signals:
Any of those four can be viewed as cautionary signs - signals that you may need to switch your money into different funds. After all, no less a fund expert than the late Sir John Templeton once advised selling "whenever something better comes along."
Known as "style drift," such changes in a fund's orientation can result in higher risks or a new focus that doesn't fit with the balance you want for your portfolio. For example, it might put more emphasis on value stocks and less on the income component you desire, or it might ease away from growth toward a more speculative tone.
This shift isn't always bad - it might even improve a fund's overall performance. But you still need to be aware of it: If the new style doesn't fit your asset-allocation plan, the overall impact could be negative in the long run - it could even elevate your risk level. Review your portfolio and what the fund's style shift does to its balance. If it's not what you want, go ahead and sell - in essence, firing the managers who are no longer doing what you hired them to do.
[Editor's Note: For the remaining five questions mutual-fund investors need to ask themselves as a central piece of any "Defensive Investing" strategy, check out Money Morning tomorrow (Tuesday) for Part II of this story, and for a related sidebar. For other stories in Money Morning's "Defensive Investing" series, please click here.]
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