The mutual fund industry's third-quarter results are in, and you've had time to compare the performance of your stock funds to others.
So what do you do if you own a fund that is clearly a laggard this year?
Especially in this kind of roaring bull market--with such a strong media focus on funds that are racking up gains of 40%, 50% or more--it's common for fund owners who are faring relatively less well to feel slighted, and perhaps itchy to sell their laggards and buy something "better."
Which strikes John Markese, executive director of the 170,000-member American Assn. of Individual Investors in Chicago, as bordering on dangerous gluttony.
"I've heard people say, 'My portfolio is doing lousy--I'm only up 20% or 30% this year.' I've never heard that before in my life," Markese says. For those kinds of returns, "people should be kissing the ground," he says.
There is definitely a time to divorce a laggard fund, Markese and other pros say, but you don't do so simply because the fund isn't the year's biggest gainer, or because it fails to beat a well-known industry proxy like the giant Fidelity Magellan fund, which was up 38.9% through the third quarter.
How do you decide if your fund is truly a laggard--and whether you should dump it?
Start with these questions:
* What, exactly, are you lagging? Be sure you're comparing apples to apples when you place your fund's results beside a market or fund-industry index. If your fund invests in smaller stocks, for example, it isn't fair to compare it to a market index such as the Standard & Poor's 500, which is a big-stock index. The S&P; gained 29.8% through Sept. 30, while the Russell 2,000 index, a widely watched small-stock index, was up 25.7%.
* Is the problem in the fund or in its sector? Some of the weakest funds this year, relatively speaking, have been "small-cap value" funds, which invest in smaller, more conservative stocks rather than the go-go growth issues--such as technology stocks--that are the rage now.
If you specifically bought a fund to invest in small-cap value stocks because you wanted to include that investment style in your portfolio, it doesn't make sense to jettison the fund because that sector is dragging behind. Market sectors roll into and out of favor over time; small-cap value is lagging now, but it could quickly revive if investors begin tiring of chasing hot growth stocks.
What's more, small-cap value funds, and funds in certain other lagging sectors this year, typically are less volatile (i.e., less risky) over time than more aggressive funds. That may better suit your temperament. "If you get into the relative-performance judging game and begin to forget what's important to you [in a fund's characteristics], that's dangerous," warns John Rekenthaler, editor of Morningstar Mutual Funds in Chicago.
* Did you buy the fund for consistent high performance--or as a hedge? Gold and real-estate-oriented stock funds have been poor performers this year. But if you own such funds as a hedge--meaning that you expect them to perform better if the market overall slumps--there may be no reason to kick them out of your portfolio.
Now, let's say you get past those basic questions and you're still faced with the cold reality that your fund is lagging the average return in its category. Is your manager simply incompetent--a lousy stock picker in a good market?
Maybe not. Consider Investment Co. of America, one of America's oldest stock funds and one of the best over the very long term. Through Sept. 30 the fund was up 23.9%, which was below the average growth-and-income stock fund's 25.5% gain.
What's ICA's problem? Its managers have been keeping a heavy share of assets in "cash"--amounting to about 20% of the fund at mid-year--rather than investing every last dollar in stocks. ICA's managers say they aren't willing to chase streaking stocks this year, preferring to keep a lot of powder dry until prices come down again.
That may depress the fund's performance in a hot market, but it also represents an insurance policy of sorts should the market suffer a big setback. If you don't want that kind of insurance--and prefer to be in a fund that's always fully invested--ICA isn't for you. Yet ICA's record suggests management knows what it's doing.
Of course, plenty of this year's laggard funds can't boast ICA's pedigree. When do you decide you've suffered enough disappointment with a fund? Most industry experts say that if your fund has lagged its category or sector-average performance not just this year but for the past two years as well, you should consider exiting.
"I think three years is plenty" of time in which to judge a fund, says the AAII's Markese. If the manager consistently lags in good markets and performs worse than average in bad markets, shareholders ought to ask what they're getting for the management fees they're paying.
Robert Markman of Markman Capital Management in Minneapolis says the issue of whether to keep or sell can be resolved by asking one question: "If you didn't own the fund, what would you do?" In other words, would you buy it fresh today, to have a stake in that market sector?
That question applies to your fund leaders and laggards alike, Markman says. If you're tempted to take profits in a hot fund, for example, you shouldn't if the prospects of the fund's stocks would lead you to buy it even now. Likewise with your laggards, the sell decision shouldn't be based on past performance but on your expectations.
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Find Your Benchmark
How to gauge your stock mutual fund's performance? First, identify the category of fund you own: Does the fund target small, mid-sized or larger stocks? Next identify whether the fund follows more of a "value" or "growth" strategy. Then compare its return to the proper market index and to the average fund in its category. *--*
Total return: Index or fund average 1994 1995* Small-cap value index -1.6% +22.2% Small-cap growth index -2.4% +29.1% Small-cap fund average -0.7% +29.2% Mid-cap value index -2.1% +29.1% Mid-cap growth index -2.2% +31.5% Mid-cap fund average -2.1% +30.2% Large-cap value index -0.6% +28.7% Large-cap growth index +3.1% +30.8% Large-cap fund average -0.9% +25.5%
* through the third quarter
Small-cap and mid-cap indexes derived from Russell 2,000 index; large-cap indexes derived from Standard & Poor's 500 index. Large-cap fund average is for growth-and-income category.
Source: Standard & Poor's; Frank Russell Co.; Lipper Analytical Services