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By Joanna Pachner
Sympatico/MSN Finance
Monday, January 1, 2007
Breaking up is hard to do, especially when money's involved. Here are some tip-offs that it's time to kiss your mutual fund goodbye.
Adrian Mastracci, fee-only portfolio manager at
KCM Wealth Management in Vancouver, says, "Successful investors know when to hold, when to fold and when to walk away from their investments. Moreover, they do it quickly and without regrets."
It started out so well. You found a mutual fund that charged low management fees and consistently outperformed its rivals. Its long-time manager put her own money in it and tended to hang on to solid investments. But then something changed. The fund's performance began to lag and its holdings to get riskier. Redemptions were rising. Was it time to call it quits?
That's one of the toughest decision all fund owners eventually face: whether to throw in the towel on an underperformer or hold out for a turnaround in the hope of recouping your losses. As many financial advisors will tell you, the main thing is to eliminate emotion from the equation. "Hope is not an investment strategy," says Adrian Mastracci, fee-only portfolio manager and president of KCM Wealth Management Inc. in Vancouver. "Successful investors know when to hold, when to fold and when to walk away from their investments. Moreover, they do it quickly and without regrets."
While the reasons to dump a fund are ultimately as unique as investors, there are some warning signs that everyone should heed.
The fund is registering unusual results: Occasional setbacks are a fact of investing life, but unusually large losses — substantially higher than those of competitors in the category — should cause concern. This is especially true if they befall a fund in a supposedly low-risk, low-volatility category such as bonds. Naturally, the longer poor performance lasts, the more reason to sell. One year may be a blip but three years or more of lagging behind peers is tough to excuse. According to mutual-fund research company Morningstar Canada, you should also be concerned if the fund gains more than it should. "If your 'moderate' balanced fund posts a 60% return when its average peer is up 10%, maybe you don't own what you think you do."
You've discovered structural problems: Most people look at a fund's performance, but that's a backward glance that tells you little about the future. If you sense trouble, look for problems under the hood — at how the fund is run. Suzanne Abboud, president of FundScope Ltd., a mutual fund research company in Richmond Hill, Ont., notes on her website that a fund where a majority of trustees or directors are linked to management risks a conflict of interest. Such directors "are not likely to bounce an incompetent manager or complain if the fees charged to investors are creeping too high," she writes.
Another issue is the cost structure. Average fund management fees have been rising regardless of performance, cutting into investors' gains and magnifying losses. According to Abboud, equity funds that charge more than 2% in MERs and bond funds with fees above 1.25% should be the first you dump when a slide sets in. As for load funds (which charge advisor commissions), don't invest in them in the first place, she says — especially ones with back-end loads, which penalize you for selling. "An amazing 60% of investors' money is now placed in load funds," she points out. "Yet, with rare exceptions, no-load funds deliver better returns in almost every investment category."
The manager has changed strategy: "Presumably, you buy a small-value fund because you want exposure to small-value stocks. If the manager suddenly starts buying large-growth stocks, you may have a problem," notes Morningstar's website. Such shifts can expose you to uncomfortable levels of risk or, conversely, provide more conservative rewards. What's more, they might mess with your portfolio mix, since you may already have sufficient exposure to the type of investments the manager is now chasing. It's wise to regularly check where your funds are invested to ensure your asset mix has the ratios you want.
Your goals have shifted: As you move through life, your financial needs and risk profile change. Young people with few obligations will have a substantial tolerance for risk, but may become more conservative once they start a family. Accordingly, they may choose to sell that volatile emerging-markets fund and put the cash into a large balanced fund. "You don't invest to win some imaginary race, but to meet your financial goals," advises Morningstar. "As your goals change, your funds should change as well."
The fund has hit your loss limit. You should figure out before you buy what it would take to make you sell: a loss of 10%? 20%? More? Committing to a selling policy up-front will help you keep emotion at bay at decision time. "That's where a lot of people go down the wrong path," says Mastracci. "They don't want to be proven wrong in their choice so they hold on to investments too long." In doing so, they fail to do the unpleasant math: if an investment is down 25%, its performance would have to jump 33% for you to break even. If it's down 50%, it would have to come back 100%. "The odds are not with you," says Mastracci. Plowing in more money during a skid in hopes of riding the comeback usually makes the situation worse (Nortel, anyone?). "In many cases it takes years of patience before a turnaround comes about. The bad news is that I can't recall many of them."
In his practice, he advises aggressive investors to set 40% as their loss benchmark; for balanced investors, he recommends 20%; and for income-oriented ones, 15%. You could also divest in steps. For example, you might decide that if an investment drops 20%, you'll sell half of it. If it subsequently drops even 5%, you dump the rest.
The fund has hit your gain limit: It's just as important to have a benchmark for profits as for losses. If your fund has been going gangbusters and you keep reinvesting the gains, you may soon find your asset mix out of whack. "You have to learn to sell some of the winners," says Mastracci. "People hate to do that, they hate to pay tax [on the gains]. But cashing in at the right time is critical to keep your portfolio balanced."
Ultimately, admitting mistakes is essential to becoming a good investor. "Making portfolio selections is not about always being right," says Mastracci. It's about being right more than you are wrong.
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