When it comes to poor performance in a mutual fund, how long is too long?
Evaluating the performance of a mutual fund is a bit different than evaluating the performance of an individual stock, chiefly because of the time frames involved. Mutual-fund investors should actually evaluate the performances of the funds they hold over a longer time period than they might use to gauge the returns generated by a stock.
Let's face it: Six-month or one-year returns on a mutual fund 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 - or even the fund's particular investing style (growth, value or momentum, for instance) - is currently out of favor.
That weakness may well be offset by another fund in your portfolio that is targeting an in-favor investing style or a strongly performing sector. And this situation could easily change or even reverse itself as economic or market 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. That's why many experts say its worth waiting for two years - or even three years - 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.
The fund has gotten too big: Some funds, particularly those focusing on micro- or small-cap issues, have trouble profitably investing all of their assets when they get too large. For example, a $100 million fund can move 5% of its assets in and out of a small stock without overly affecting its price. But if that fund swells to $500 million, that same 5% in a single micro-cap stock will likely affect the share price. This will increase the fund's cost basis and also make it harder to sell the shares later, reducing the profit and the return on the investment. The only alternative is for the manager to buy a larger number of small stocks, or turn to larger companies, both of which reduce flexibility and, ultimately, lower performance. (Some fund families anticipate this problem and close their small-cap funds to new investors. If yours doesn't and you see performance moving inversely to asset growth, consider heading for the exit).
The fund has done too well: If your fund has produced unusually high returns, and you don't feel it can sustain them (perhaps because of "sector rotation," a large number of overbought holdings or one of several other reasons), you may wish to shift your money into a more-defensive fund, or one that has more potential upside ahead of it.
The competition is doing it better: If another fund moves into a particular sector with better analysis or other innovations that let it get earlier signals or more-favorable prices, your fund's performance will quickly suffer by comparison. Don't forget: No less a fund expert than the late Sir John Templeton once advised selling "whenever something better comes along."
Your fund changes managers: As we often see with our favorite sports teams, star managers can be lured away by the competition. Others get fired, often on the basis of factors (egos, clashes with the board or top management, demands for more money or a "piece" of the business, for example) that don't involve performance. If a new manager has a slightly different investment style, changes analysts or simply has poor timing, it could explain a drop in your fund's results.
[Editors' Note: For the main story on defensive-investing strategies involving mutual funds, please click here for Part I, which appeared yesterday (Monday), and here for Part II, which appears elsewhere in today's issue of Money Morning. For other stories in Money Morning's "Defensive Investing" series, please click here.]