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Should You Hold Or Fold A Poorly Performing Mutual Fund?

October 2016


First of all, ALL funds go through periods of time where they are performing “poorly,” either relative to other similar funds or in absolute terms. Even Warren Buffett has gone through many and sometimes long stretches of under-performance. So how do you know whether you should hold ‘em or fold ‘em? Here are some questions to ask:

How is the fund doing relative to its benchmark? The benchmark is a way to measure the performance of a fund relative to its investment category. For example, the benchmark for funds that invest in large companies in the U.S. is typically the S&P 500 Index, which is 500 of the largest companies in the U.S. The reason you want to compare your fund to its benchmark is because the performance may still be okay even though the investment category (like large U.S. stocks) may be simply out of favor.

All types of investments go through cycles, but unfortunately, it’s impossible to reliably time these cycles and selling when an investment is in a down cycle just means that you’ll miss the possibility of a recovery. In fact, buying an investment when it’s in an up cycle results in buying when it’s priced relatively high, which is the opposite of the mantra to buy low and sell high. If your fund is down relative to the rest of your portfolio simply because its investment category is down, you might want to actually invest more in it by re-balancing your portfolio.

For example, let’s say you pick a portfolio of 60% stocks and 40% bonds based on your time horizon and risk tolerance and the stock market is down, causing your “poorly” performing stock funds to end up being 50% of your portfolio. Rather than selling them, you would re-balance your portfolio by moving enough money from your bond funds to the stock funds to return your portfolio to the target 60/40 split. If the stock funds continue falling, you’d continue buying more to re-balance. When they eventually rebound and end up being more than 60% of your portfolio, you’d re-balance by moving money out of the stock funds into the now “poorly” performing bond funds to maintain your target risk level. This forces you to buy funds when they’re priced relatively low and sell them when they’re relatively high which can potentially boost your returns.

Are the fund’s costs higher than average? When you’re comparing funds in the same category, studies have found fees (in the form of the fund’s “expense ratio”) to be the biggest predictor of future long-term performance relative to similar funds. Namely, lower cost funds tend do much better than higher cost ones. In addition, the fund’s “turnover” ratio or how often the fund trades can indicate how much you’re losing to transaction costs that further eat away at your returns.

Is the fund doing poorly relative to its benchmark even with low fees? This could simply be due to bad luck with the fund manager’s picks. (Don’t underestimate the role of luck in mutual fund performance.)

You can minimize this “management risk” by choosing passively managed index funds. These funds simply track their benchmark so there’s no risk of a manager making bad bets. They also tend to have the lowest fees and turnover.

Is the fund in a taxable account? Even if you don’t want to get rid of the fund long term, you can turn losses into lemonade by selling the fund and using the losses to offset other taxes (including up to $3k a year of ordinary income taxes with the excess losses carried forward indefinitely). To take the loss off your taxes, you just can’t purchase the same or an identical fund 30 days before or after the sale. Instead, you can reinvest the proceeds in a similar but different fund and/or wait 30 days to repurchase the fund you sold to benefit from any rebound.

Just because a fund is performing “poorly” doesn’t mean it’s actually a poor investment. Even the best funds have bouts of under-performance from time to time and many of today’s losers will be tomorrow’s winners. Of course, some really are just poor funds. The key is knowing how to tell which is which.


This article was written by Erik Carter from Forbes and was legally licensed through the NewsCred publisher network.

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