Sooner or later, even a good mutual fund will fall into a rut. That's normal. Sometimes the slump lasts for only a few months. On other occasions, things go from bad to worse. How can you tell when it's time to get out?
Unfortunately, there are no easy answers. In many respects, it's more difficult to know when to sell than to buy. Professional advisers usually weigh several factors before recommending that investors bail out of a fund. They look for changes in the fund's performance, management, asset base and more.
Of these danger signals, poor performance looms as the most critical. "This is the biggest flag," says Jack Walsh, editor of the United Mutual Fund Selector newsletter in Wellesley, Mass.
However, it's not enough simply to spot a lagging fund. You've got to find out if there's a genuine problem. Sometimes the underperformance can be explained--in fact, predicted--by the fund's investment objectives.
For instance, you can expect "defensive" or low-volatility stock portfolios to lag during market rallies. These funds aim to minimize losses, so they will forsake some upside potential to reduce risk.
"You should watch the relative performance of your fund, but you need to compare it to that of similar types of funds," says Walter Rouleau, editor of the Growth Fund Guide newsletter in Rapid City, S.D. Defensive equity portfolios routinely hold cash and sometimes even bonds to guard against a possible stock market reversal.
So don't panic if your fund lags the bellwether Standard & Poor's 500 or other market indexes. But you should be concerned if it trails other funds in its group for several months or more. That's been the case lately with Mutual Shares and Vanguard Windsor, two growth-and-income portfolios with exceptionally good long-term records.
At the start of 1989, these two legends were ranked No. 3 and No. 12, respectively, out of 361 mutual funds with 15-year records, according to Lipper Analytical Services. Since then, however, both Mutual Shares and Windsor have been beaten by the average growth-and-income fund, as well as by the S&P; 500.
After a year and a half of relatively poor numbers, should investors throw in the towel? No, says Craig Litman of Litman/Gregory & Co., a San Francisco money management firm specializing in mutual funds. He cites the funds' excellent long-term records and notes that defensive portfolios of this type will typically underperform during bull markets.
Litman also points out that the managers who chalked up the good long-term numbers--John Neff of Windsor and Michael Price of Mutual Shares--are still at the helm. If the funds had gotten new leadership and then started to falter, that would have been a danger signal, Litman says. "The most important reason to get out of a fund would be a change in managers."
Walsh agrees that you need to watch a personnel transition closely. His newsletter downgraded Fidelity Magellan from a "buy" to a "hold" as a result of Peter Lynch's resignation as portfolio manager on May 31. Walsh concedes that Morris Smith, Lynch's successor, has a good track record of his own, yet he questions whether Smith can duplicate Lynch's performance. "With all due respect to Morris Smith, there are very few Peter Lynches," he says. "There are maybe 40 to 50 top managers out of 3,000 funds."
Perhaps the only time you need not be concerned about the loss of a proven portfolio manager is when the fund follows a team approach. At Twentieth Century Investors in Kansas City, Mo., for example, five managers have a hand in running all seven equity funds, selecting stocks according to a rigid discipline that keys on accelerating earnings. Twentieth Century's funds could probably continue to perform as well as ever even if one or two managers left.
The American Funds Group in Los Angeles also follows a team approach to investing.
Many experts also would consider a radical drop in a fund's asset base as a possible sell signal. There's nothing unusual about a portfolio that shrinks during bearish phases. But be careful when assets fall significantly while the market is rising.
That could indicate poor stock selection, inferior shareholder services or other problems. When assets decline, the fund's costs must be spread over a smaller base, which usually results in a greater burden for the remaining investors.
In addition, when a fund adds an annual 12b-1 fee, that will tend to raise expenses for all shareholders and hurt performance. If the charge exceeds 1% or so a year, you might want to sell.
And there are other red flags, such as a fund that radically departs from its stated investment policy. This would include a small-company portfolio that starts purchasing large stocks or a growth fund that buys bonds. Fund companies must put a significant policy change up for shareholder ratification. "A proxy vote to adopt new investment tactics might be a sell signal," Litman says.
But even a new manager, a shrinking asset base or a change in investment policy will show up eventually in the performance numbers. For this reason, some advisers suggest that you worry about just one thing: a downward trend in the fund's price.
Bert Dohmen, editor of the Wellington Letter in Honolulu, belongs to this camp. He believes that everything good or bad about a fund will already be reflected in its price trend, so there's no sense in trying to analyze much else. "I don't care what the bullish or bearish factors are--just that they exist."
Dohmen suggests using a "trailing stop loss" to determine when to sell. This is a simple system to follow. You merely decide to redeem your shares when the fund drops by a predetermined amount. For example, if the average weekly price declines until it's more than 10% below the high for the previous 12 months, you would sell. "This helps you avoid big trouble without forcing you out of the market during moderate corrections," he says.
All you have to do is keep track of the current price in relation to the 12-month high and figure out how big a decline you could stand to sustain. Dohmen recommends selling after a 10% drop, since a normal market correction would run 5% to 8%, he says.
The hardest part about this approach is following it rigidly: You need to be sufficiently disciplined so that you don't do any second-guessing. "When I get a sell signal, I sell," Dohmen says. "I don't ask why."
A WAY TO CUT LOSSES
While there's no foolproof way to know when to sell a mutual fund, a "trailing stop loss" can at least minimize the damage from a significant price drop. Bert Dohmen, editor of the Wellington Letter in Honolulu, suggests that you redeem shares as soon as a fund declines 10% below its high price for the previous 12 months. In the following example, you would ride out all short-term fluctuations until the fund falls to $16.20, down 10% from its peak of $18.
An automatic discipline such as this can help remove emotions and judgment calls from the sell decision. However, you will eventually face another key question: When to buy back in?
HOW MUTUAL FUNDS PERFORMED
Average total return, including dividends, in percent for periods ended Thursday, June 28
Fund Type Notes 12 mos. Yr. to date Week Strategic Gold/Minerals AU L -4.56% +6.38% +5.26% Strategic Investments AU L -13.59 -41.06 +4.90 U.S. Gold Shares AU NL +2.00 -28.63 +3.84 Japan Fund PC NL +17.17 -3.35 +2.87 International Investors AU L +7.19 -23.61 +2.47 Putnam Health Science H L +38.04 +13.36 +2.44 CGM Capital Development G NL +23.94 +16.66 +2.39 Fidelity Select Medical H LL,R +33.04 +9.93 +2.39 Plymouth Europe EU L * +7.70* +2.38 Steadman Investment G NL -1.46 +1.50 +2.27
* Fund established 4/23/90
Fund Type Notes 12 mos. Yr. to date Week Prudent Speculator: Large Cap Fund CA NL -7.00% -3.96% -3.96% American Investors Growth Fund G L +15.14 +6.20 -3.31 Franklin PA: Equity Portfolio CA LL +3.50 +0.41 -2.86 Fidelity Select Financial FS LL,R -6.99 -5.00 -2.74 SLH 1990s Fund G L * +18.95* -2.69 Pilgrim Preferred Fund FI LL -28.72 -16.91 -2.58 Steadman Associated Fund EI NL +9.59 +5.26 -2.44 Fidelity Value Fund CA NL -1.63 -4.35 -2.36 Fidelity Select Regional Banks FS LL,R -11.40 -10.53 -2.34 Sherman, Dean Fund CA NL -1.78 -15.02 -2.25
* Fund established 2/23/90
TYPE: AU=gold, B=balanced, CA=capital appreciation, CV=convertible securities, EI=equity income, EU=European regional, FI=fixed income, FS=financial securities, FX=flexible portfolio, G=growth, GI=growth and income, GL=global-international and U.S. stocks, GX=global flexible portfolio, H=health/biotechnology, I=income, IF=international, MI=mixed income, NR=natural resources, OI=option income, PC=Pacific regional, RE=real estate, S=specialty/misc., SG=small company, TK=science and technology, UT=utility, WI=world income.
NOTES: NL means no sales charge, LL means sales charge of 4 1/2% or less; L means sales charge of greater than 4 1/2%; R means redemption fee may apply.
Source: Lipper Analytical Services