Before Cashing Out, Put Your Underperformer to the Test

By PAUL J. LIM

Oct. 6, 1998 12 AM PT

TIMES STAFF WRITER

Once upon a time, Neuberger & Berman Focus and PBHG Growth were at the top of their games. Focus was the second-best performing mutual fund in its category in 1992. And PBHG Growth was No. 1 among its peers in 1993.

But lately, both have stumbled--badly. Year-to-date, Focus is down 15.8% while PBHG Growth is down 21.1%. Over the last 12 months, Focus has lost 20.9% and PBHG Growth 27.9%.

Those are big numbers, and they might well provoke a knee-jerk reaction among the funds’ shareholders: that is, to sell. But would that be the right decision? Is it time to unload either of these funds? In general, how do you know when it’s time to give up on a mutual fund that has lost its luster?

“The most difficult decision in investing is selling,” said Doug Fabian, editor of the Huntington Beach-based Fabian Investment Resources newsletter, which publishes a “Lemon List” of funds to sell.

“There’s so much out there recommending what you should buy and how you should buy,” he added. “But there’s not a whole lot written about selling funds.”

Investors may choose to sell funds for many reasons--such as to rebalance their portfolio, follow a favorite fund manager or just because they need the cash.

But the third quarter of 1998, one of the worst periods for stocks in decades, has highlighted the reason most investors look to sell: poor performance. Yet what appears to be the simplest approach--sell ‘em if they lose your money--can often lead investors astray.

Better to pause and approach the sell decision analytically. Start by understanding a few basic lessons about fund evaluation:

Lesson No. 1: Don’t judge a fund in a vacuum.

Stock markets worldwide have lost value this year, so expecting your fund to make money in this environment is probably unreasonable. The average U.S. diversified stock fund is losing money on a year-to-date and 12-month basis, according to Morningstar Inc.

“Fine,” an investor who owns Focus and PBHG Growth might then decide. “Focus has lost less than PBHG Growth year-to-date and over 12 months. I’ll keep Focus and dump Growth.”

Lesson No. 2: When judging fund performance, compare apples with apples.

While it’s true that Focus and PBHG Growth both invest in U.S. stocks, Focus is classified by Morningstar as a “large-cap value” fund. That means it invests in big U.S. companies whose shares tend to sell for lower price-to-earnings and price-to-book-value ratios.

PBHG Growth, on the other hand, is a “mid-cap growth” portfolio, meaning it aims to invest in faster-growing, small to medium-sized companies whose stocks sell for higher P/E and P/B ratios.

“A large-cap value fund is designed to perform differently from a mid-cap growth fund,” noted Peggy Ruhlin, a financial planner in Columbus, Ohio.

Assuming you invest in these distinct funds to fulfill different roles within a diversified portfolio, “If you compare the two against each other, you’ll be deluding yourself,” Ruhlin said.

Just as PBHG Growth has lost more than Focus this year, the average mid-cap growth fund has lost more than the typical large-value fund.

Point taken. But then the investor who owns both of these funds might say, “OK, I know that the average large value fund is down 3.1% year-to-date. And Focus is down five times as much. I should dump Focus.”

Lesson No. 3: Don’t rely on short-term performance.

An investor who makes decisions based solely on year-to-date returns may think that Steadman Investment--a real dog of a large-value fund that happens to be up 11.2% this year--is a screaming buy. But if that investor looked harder, he or she would have noticed that Steadman Investment has lost money on an annualized basis over the past one, three, five, 10 and 15 years. (Fortunately, the fund is closed to new investors.)

And that same investor would have overlooked the fact that while Neuberger & Berman Focus is trailing its peers badly in the short term, it’s holding its own on a five-year annualized basis and actually has beaten its average peer over the past decade.

Now that you know how not to sell a fund, what should prompt the sell decision?

To start, divide your various mutual funds into two groups. In the first, list the funds that are held in a tax-deferred account, such as a company-sponsored 401(k) retirement plan, individual retirement account (IRA), or Roth IRA. In the other, list funds held in regular taxable accounts.

Then proceed with these steps:

Tax-Deferred Fund Accounts

Step 1: Determine the investment category for each fund.

For instance, if you own Janus Twenty, you should list that as a large-cap growth fund. If you own Scudder International, list it as an international fund. And if you own Northeast Investors, classify it as a high-yield bond fund.

The Times’ A-to-Z quarterly fund listings on pages C16 through C18 today include each fund’s category, according to Morningstar. The category abbreviations are spelled out in the charts on pages C12 through C15.

Step 2: Determine how well each fund has performed on an annualized basis over the last one and three years.

You’ll often hear financial planners, like Dick Wagner in Denver, say: “You ought to be willing to give a fund at least two or three years” to prove itself, before you give up.

That’s sound advice. But all too often, fund investors take that to mean they must wait an additional three years on a fund. Rather than start the clock from the day you made your investment, keep track of the fund’s performance over the past one and three years, regardless of when you bought. This way, you don’t have to give an underperforming fund like Steadman Investment another three years to lose money for you.

The Times’ special quarterly fund listings today (pages C16-C18) show year-to-date and three-year performance for each fund.

Step 3: Compare your fund with its category average.

Today’s report also includes average fund performance by investment category in a chart on C6 (for bonds, C11) and in the tables on C12 through C15.

Step 4: If your fund has underperformed its category average both year-to-date and over three years, consider selling.

Sometimes, laggard funds roar back. But the longer the period of underperformance, the further behind you may fall in meeting your financial goals.

Still, you may have other considerations. Before selling, ask the following:

* If the fund is in your 401(k), is there another fund offered within the plan that invests in similar assets? For instance, let’s say you want to dump an underperforming small-company stock fund. Does your 401(k) plan give you the option of investing in another small-cap fund with a better one- and three-year track record?

* If the answer to the first question is no, do you have enough money to invest in a similar fund in a taxable account? For instance, if your 401(k) plan offers only one small-cap fund, and you sell out of it, do you have enough money outside the plan to invest in another small-cap fund--to ensure that your overall portfolio retains proper diversification?

* Is there a good explanation why a particular fund may have done worse than its peers on a year-to-date and three-year basis?

For instance, let’s say you’re thinking about selling Neuberger & Berman Focus. As the name indicates, this fund is focused, or “concentrated.” That means it holds fewer stocks than its peers and places bigger bets on each of those companies. When the bets win, the fund outperforms significantly, as it did in 1992 and 1995. When the bets lose, the fund underperforms significantly, as was the case in the third quarter.

If you bought the fund because you wanted its “concentrated” features, then you probably shouldn’t complain just because it’s down over the past one and three years. If, however, you bought it solely to satisfy the large-cap value portion of your portfolio, then you might well want to think about selling and finding a better fund.

Step 5: If, after answering the questions in Step 4, you can’t justify holding an underperforming fund, sell it in favor of a better fund.

It’s often easier to make this decision within a tax-deferred account, if only because you won’t incur a tax bill for shifting. But make sure you aren’t jeopardizing the long-term capital appreciation of your retirement account. Selling a growth fund to jump into a better growth fund is one thing. Jumping out of stock funds entirely for the “safety” of cash is another.

Taxable Fund Accounts

For funds you own in taxable accounts (i.e., not in deferred retirement accounts), follow steps 1 through 4 listed in the tax-deferred section, then go on to the following:

Step 5: If your fund has underperformed year-to-date and over the last three years, factor taxes into a possible sell decision.

An easy way to do this is to consider selling a fund only if its one- and three-year returns aren’t at least 80% as good as its category average. For instance, the average large-cap growth fund has delivered annualized returns of 18.2% over the last three years. So you might consider keeping a large-cap growth fund even if it has delivered three-year annualized returns of just 14% or 15%.

Why should you settle for an underachiever? “The biggest reason we don’t pull the trigger is because clients could face such a huge taxable capital gains bill by selling,” said Ruhlin, the financial planner.

“You have to ask yourself: ‘Is this fund’s underperformance bad enough that it’s worth incurring a tax liability?’ ”

Finally, there’s another reason to think about taxes before selling an underperforming fund. You may still be receiving taxable capital gains distributions this year, even from funds that have performed terribly.

That’s how mutual funds work. They must pay out their realized capital gains each year to shareholders. Even if a fund drops in value, the manager may still have generated taxable gains.

So ideally, you should be looking to sell underachieving funds in which you’ve actually lost money--say, an emerging-markets fund that you purchased two years ago.

That way, you’ll have losses to offset whatever capital gains you receive from other funds, this year, and you’ll also be able to buy into what you hope will be a better fund choice within the category in which you’re selling.

Now, after all that, should an investor dump Neuberger & Berman Focus and/or PBHG Growth?

Clearly, neither of the funds comes even close to achieving 80% of the returns of their category averages over the past one and three years. Provided you have other large-value and mid-cap growth options, many experts would say: sell them.

Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.

What’s Inside

* Exclusive tables showing the best-per- forming funds over the last three years in each major stock and bond fund category, ranked and rated by fund tracker Morningstar Inc. Beginning on C12. And check your fund’s per- formance in A-to-Z ta- bles beginning on C16.

* Seven stock funds that have regularly performed better than peers in times of troubled markets. C5

* Where to look for fund bargains as mar- kets slump. C10. How bond funds fared. C11.

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Mutually Troubling

The average U.S. diversified stock mutual fund plunged 15.2% in the third quarter, the worst quarterly drop since the third quarter of 1990. The average fund was off 5.2% year-to-date through Sept. 30. Only a fourth-quarter market rally can keep the funds from experiencing their first down calendar year since 1994. Annual total returns, and the total return for the first three quarters of this year, for the average U.S. fund:

‘88: 16.0

‘89: 25.4

‘90: -5.9

‘91: 37.4

‘92: 9.9

‘93: 13.3

‘94: -1.3

‘95: 31.6

‘96: 19.9

‘97: 24.4

‘98: -5.2

Where It Hurt Most