Time to Squeeze Those Lemons?
Thousands of mutual funds have performed terribly in this long bear market, yet many investors continue to hold on for dear life. But letting go of your losing funds and reaping the tax benefits is one way to turn your lemons into lemonade. By selling, you realize capital losses that reduce your capital-gains tax bill. If you don't have any gains, you can still write off $3,000 of losses against your income and carry the rest forward to nullify gains in future years. Even if you like a fund, you can buy it back 31 days after selling it; the Internal Revenue Service will allow the write-off.
Taxes aren't the only reason to sell. "Poor performers are often likely to continue to lag their peers," says Mark Riepe, senior vice-president of the Schwab Center for Investment Research. According to a study Riepe conducted, investors who dump a fund after one year of lagging other funds with the same investment style outperform those who buy and hold the laggard for three years. The key is that you don't just sell and move to a money-market fund. You purge, say, your lousy large-cap growth fund and replace it with a better one. Of course, you need to factor in trading costs and sales charges before making this decision.
Before you take the final step to sell, you must decide whether the fund's underperformance is acute or chronic. "Any fund can have a bad quarter, which can throw off the whole year," says financial planner Louis Stanasolovich of Legend Financial Advisors in Pittsburgh. Stanasolovich will put a fund on a "watch list" to sell only after it underperforms its peers for three straight quarters. If the fund continues to lag in the next three quarters, he dumps it.
A screen run by Morningstar of $500 million-plus funds that have lagged for the past three quarters found 186 possible sells. Since this is the second time BusinessWeek has compiled this list (May 14, 2001), some familiar names cropped up--Putnam OTC Emerging Growth, Fidelity Aggressive Growth, Putnam Voyager II, RS Emerging Growth. "I'm almost embarrassed to beat up on Putnam OTC Emerging Growth," says Roy Weitz, publisher of FundAlarm.com. "It has been on sell lists for years." Assets are $1.6 billion, down from $15 billion in 1999.
The list has some notable newcomers. The largest were the $53 billion Fidelity Magellan Fund, which lagged the average large-cap blend fund by 3.2 percentage points over the past three quarters, and the $16 billion Vanguard Windsor Fund, which trailed the large-cap value category by 6.4 percentage points. These losses are probably not great enough to warrant an immediate sell. But funds like MFS Mid-Cap Growth and White Oak Growth Stock Fund, which are trailing their peers by 28.1 and 21.3 percentage points, respectively, are candidates for dumping. Most surprising was Vanguard Capital Opportunity, which has a solid long-term record but lagged its peers by 18.1 percentage points. "We have no excuses," says portfolio manager Theo Kolokotrones. "We were premature moving into the tech space, thinking there would be a recovery."
In his defense, White Oak portfolio manager Jim Oelschlager says the fund is more concentrated--has fewer stocks but more shares of them--than other large-cap growth funds, making it more volatile on the upside and downside. "Concentrated funds tend to do better than their peers when the market's up and worse when it's down," he says. Roland Gillis, who runs Putnam OTC Emerging Growth, also blames the fund's lag on a more "aggressive" investment style--taking positions in more risky stocks than its peer group. Still, other concentrated large- growth funds, such as Marsico Focus and Bramwell Focus, and other aggressive funds, such as SSgA Aggressive Equity Fund, have outperformed these two funds and their peers despite the bear market.
Some funds genuinely don't fit in their categories and may deserve a stay of execution. Vanguard Precious Metals Fund has historically invested a large percentage of its assets in platinum producers. Most other funds in the precious-metals group focus mainly on gold. Now that gold stocks are in vogue, Vanguard's fund is lagging, but its long-term record is among the best in the group.
If you are ready to sell a fund, decide ahead of time what you plan to buy in its place. You could use Morningstar.com's star ratings as a guide. The firm rates mutual funds from five stars down to one based on how well they've performed on a risk-adjusted basis versus their peers. So if you want to dump White Oak Growth Stock, which sports a two-star rating in the large-cap growth category, you could replace it with Jensen Fund, which receives five stars in the same group.
Investors in taxable accounts should take their analysis of potential replacements a step further. Mutual funds have realized huge losses in the bear market, but the law doesn't allow them to pass the losses on to shareholders. Instead, the losses remain with the fund, and the manager can apply them to future gains. That allows the fund to avoid making taxable distributions when the market rebounds.
Of course, you don't want to buy just any fund with losses. The key is to find a good one that has suffered because of the market slide. The table lists funds with large losses on their books that have received at least four stars from Morningstar. The statistic known as capital-gains exposure measures what percentage of a fund's current assets are gains. When this figure is negative, as it is for many funds now, the fund has losses. Some highly rated funds such as Janus Olympus and Kinetics Internet have losses in excess of their current assets. They won't be making any capital gains distributions for a long time.
By Lewis Braham