Pulling the plug on a fund is perhaps the most difficult part of the investment process. What's eminently clear from our conversation with financial planners Michael Maloon, Eleanor Blayney and Ross Levin is that sell decisions are anything but formulaic.
Morningstar: What are some general reasons to sell a fund?
Michael Maloon: If a fund doesn't meet your original buy criteria for two consecutive quarters, it is a trigger point. The trigger tends to be performance, because if you're a low-expense, low-turnover manager, chances are you'll remain a low-expense, low-turnover manager.
Eleanor Blayney: When we see deviation in performance, we want to understand why. This is true on the upside as well as the downside, because we want to see if significant risks are being taken or if the investment philosophy has changed. Underperformance on a one-year basis would not be an automatic sell. Underperformance on a three-year time frame relative to a benchmark or Morningstar category is, however, a flag.
Ross Levin: If we think the fund manager has changed his or her discipline in any way, or has style drift because so much money has come in that he or she can't buy micro-caps or something like that, then that's one of our sell triggers. If there's a manager change, that creates a red flag. If the fund gets too big, it will trigger a sell decision. And relative performance matters.
Morningstar: Let's take these one at a time. How do you define underperformance, Ross?
Levin: The way to define it is relative to benchmarks. All managers have periods of tired returns, and the question is do we believe that their tired returns will be followed by strong returns? If the story is the same, if the manager hasn't attracted too much money, or if he is still committed to doing the things he did before, we tolerate short-term underperformance.
Morningstar: What would be short-term?
Levin: Short-term is 18 months to two years. We'll tolerate underperformance longer on the value side, though, and we will go up to three years if we believe their story and if we like what they are telling us. Value isn't always realized right away.
Morningstar: How long would you tolerate underperformance, Michael?
Maloon: After two quarters I start to get concerned. We talk to the manager to find out what happened. Every now and then you are going to get cases where things just happen, random bad luck, and I don't think you fire a fund over that. But if you determine that it is a consistent pattern of missteps, that is when you start to consider making a move. A manager's pedigree matters too. So I would give a Michael Price, a Jean-Marie Eveillard, a little more patience.
Morningstar: Give us an example of a fund you've sold recently.
Maloon: Lindner Dividend. It evolved into a preferred-stock-and-bond fund. They just got too darn conservative. Now it botches up the asset allocation because it is not a stock fund, it is not a bond fund.
Morningstar: Eleanor, for funds outside of retirement accounts, how do you evaluate whether to hold on to a poorly performing fund or sell it and pay taxes on the gains?
Blayney: You would sell because you have another place for that money where you expect to pay yourself back for the tax hit. In other words, your new fund will surpass the fund that you fired, as well as compensate for the amount that went to taxes. The larger the tax bite, the better your alternative investment has to be.
Levin: When selling an underperformer, it matters whether you have a short-term or long-term gain. The spread between the 39.6% and 28% brackets is big, and the spread to 20% is even bigger. So it may make sense to accept underperformance to get us out to that 18-month holding period. [The maximum capital gains tax on investments held 18 months or longer is 20%.] But beyond that we don't think there is a ton of value in holding on.
Morningstar: Do you sell funds if their managers leave?
Blayney: A manager change isn't an automatic out. When you see a manager change, you need to see that the style is being carried forward. Simple or formulaic approaches seem to be transferable across managers.
Maloon: If Jean-Marie Eveillard is suddenly working with Janus Fund next week, then that's where we are. But if I would have hired the new fund manager based on what I can find out about him or her, then I will hold on to the fund. That is going to be rare, though. Most times, certainly in an IRA account, we are out after a manager change, because for any given style category I may have two or three funds that I just can't wait to get into the mix. In a taxable account, we have to weigh how much money we are going to pay in taxes.
Levin: Sometimes a new manager overhauls the portfolio so dramatically that the fund pays out huge capital gains anyway. So you might think you'd be saving taxes by holding on to the fund, but you really are not.
Morningstar: Do you follow managers to their new funds?
Blayney: We have not done that.
Levin: We eventually followed John Bogle Jr. to Numeric Investors after he left Quantitative Group. We didn't do it right away, though, because we wanted to see what the new manager at Quantitative would do.
Morningstar: Why did you follow him?
Levin: We believe in manager ability, and we think the passion that people like Bogle have is value added that's worth owning.
Morningstar: Last month, Morningstar Fund Investor unveiled findings that showed asset size matters most for growth funds. Are there instances when you'd sell a fund because it's too big?
Levin: It depends on the type of fund. In the small-cap arena, I believe you start to get into trouble above a billion dollars in assets. We also think asset size matters in funds that historically have gotten their returns from a concentrated portfolio.
Maloon: Size is an issue. At $10 [billion] to $15 billion in assets, we start to think large-cap funds are getting pretty big. If you have a couple of billion dollars in a mid-cap fund, that's pretty big. The average small-cap fund has $228 million in assets, so if you get above a billion, you're pretty big.
Blayney: If we see asset growth of over 100% a year in a stock fund, that raises some warning signs. Again, it is going to depend on what their universe is and on their field of play. Can the fund still be nimble?
Morningstar: How about funds that have changed styles and now invest in different kinds of stocks than they had originally? Are they sells?
Blayney: Generally we are looking for a fund to fill out a style allocation. In that case we want faithfulness to the style. Style drift in a very active, flexible fund is not as important.