Hasta la Vista, Baby

When to dump a mutual fund

Did your jaw drop when you read your latest quarterly mutual-fund statement? The past year has been so brutal, many investors are paralyzed with fear. But if your funds are seriously underperforming, you can't just sit there. You must sell. "Selling is a bad word in the investment world," says Edward Foster, chief investment strategist at Fabian Investment Resources, an investment advisory firm in Huntington Beach, Calif. "But in order to take control of your financial life, you need to have a sell discipline."

If you're like most investors, you fall into one of two camps. You sell at the first sign of negative performance or you hold on for dear life, no matter what happens. Both strategies are flawed because they're based on an emotional response instead of a rational assessment of performance.

What you should do is buy or sell a fund based on its performance relative to its peer group. "We compare a small-cap value fund's return to other small-cap value funds and the Russell 2000 Value Index," says investment adviser Louis Stanasolovich of Legend Financial Advisors in Pittsburgh. That way you can sort out funds that are down because they invest in an unpopular sector from the true laggards.

The timing of the sale is also important. According to a study conducted by the Schwab Center for Investment Research, investors who sold and replaced loser funds after just one year of underperformance garnered a 13.4% annualized return from 1987 through 1996. If you waited three years to sell, your return fell to 12.5%. Stanasolovich improves upon this formula. He'll "watchlist" a fund to sell if it lags its peers three straight quarters. That way, he doesn't punish funds with only one bad quarter.

"LEMON LIST." By those standards, plenty of behemoths are worth dumping. A screen run by Morningstar of funds with more than $1 billion in assets found 141 potential sells. The poorest performers (table) were Putnam OTC Emerging Growth, Morgan Stanley Dean Witter High-Yield Securities, and Janus Enterprise, lagging by 53.5 percentage points, 29.2, and 28.9, respectively. If the performance lag is small, you may want to hold for an additional three quarters to see if there's any improvement. But there's no reason to keep Putnam OTC Emerging Growth. "This fund has lost investors money on a one-year, three-year, and five-year basis," says Foster. "Yet there's still $3.5 billion invested in it." Because of that track record, Putnam OTC tops Foster's "lemon list" of sell-worthy funds, which is available free if you register at www.fabianlive.com.

In the previous case, you would sell Putnam OTC and buy a better mid-cap growth fund, so you don't miss any upside in that sector. At BusinessWeek's Web site, you can search for replacements. Go to businessweek.com/investor/funds.html. Click on the Interactive Mutual Fund Scoreboard. Select "Equity Funds" for "Fund Type," "Mid-cap Growth" for "Display," and "BW Ratings" for "View." The ratings, which run from A to F, are based on the past five years' risk-adjusted total return. Among the options: Calamos Growth and Vanguard Capital Opportunity.

LUMBERING GIANTS. Why do funds underperform? Poor investment choices, for sure, but sometimes they are exacerbated by "asset bloat"--the fund is just too big to be nimble. In fact, a good way to avoid future laggards is by selling oversize funds. How big is too big? It depends on investment style. According to one study by Morningstar, at small- and mid-cap growth funds that trade aggressively, performance starts to decline after assets pass $150 million; at large growth funds, $4 billion. Value funds that buy and hold can grow larger before sluggishness sets in.

Many large, aggressive growth funds have cost their shareholders dearly. They include Fidelity Aggressive Growth, Fidelity OTC, Putnam New Opportunities, MFS Emerging Growth, and Janus Enterprise. All have more than $4 billion under management and have underperformed their peers by more than 18% over the past three quarters. All started as small- and mid-cap funds but now buy large stocks that are easier to trade. Such "style drift" is another reason to sell, especially if you own other large-cap funds.

Portfolio manager Jim Goff of Janus Enterprise says it isn't asset size that has hurt performance but the market punishing his tech and telecom stocks, such as Crown Castle International (TWRS ) and SBA Communications (SBAC ). "They have strong fundamentals, but they have been dragged down by guilt by association," says Goff. Perhaps, yet sister fund Janus Orion Fund, with only $673 million in assets, has beaten Enterprise handily in the past three quarters, and it's heavily invested in those sectors.

Both Fidelity and MFS argue that their lagging funds are much more aggressive than their peers in the large-cap growth category. Jessica Catino, a Fidelity spokesperson, says that Fidelity OTC should be compared with the Nasdaq Composite Index, which it has beaten in the past year but lagged over the past decade. Putnam had no explanation for the current lag at its funds, but noted that their 10-year track records were good. Yet a smaller, more nimble rival such as Bridgeway Aggressive Growth Fund is just as aggressive and has beaten all of these funds on a one-, three-, and five-year basis. Why stick around?

A management change can be a sell sign but not always. In a laggard, such as Morgan Stanley Dean Witter High-Yield Securities, it could be a blessing. This January, the firm replaced Peter Avelar with Stephen Esser, the top-performing manager of MAS High-Yield Institutional Fund. Esser might improve returns, but manager changes bring other issues. If the new manager dumps the prior manager's holdings, you can get hit with a large capital-gains distribution.

When you're dealing with taxable accounts, selling is a little dicier. If you have unrealized gains in the fund, you have to weigh the tax consequences of selling against the opportunity cost of holding on to a laggard. If you have capital losses in a fund, you should sell it and use the losses to offset capital gains at other funds.

Ideally, you should have a sell discipline in place before buying a fund. "When funds go down isn't the time to figure out when to sell," says Foster. By setting performance boundaries beforehand, you can get out before losses become unbearable.

By Lewis Braham

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE