Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. An earlier version of this article appeared Feb. 17.
"Let me give the truth up front--I don't know." MBAFBA
"I've been wrong on this many times." Zorkl55
"It depends. It always depends." TheRebelWhisperer
Those were a few of the refreshingly candid responses to my Discuss forum query about how to know when to sell a fund, and these ambivalent investors are clearly far from alone. Although a handful of respondents said that they hew to black-and-white performance metrics when deciding whether to give an investment the heave-ho, others said they use poor performance as a reason to add to their holdings when they're down.
Many others said that knowing whether to sell is more art than science. Performance may play a role, but so do fundamental factors such as manager and strategy shifts and stewardship issues. Other respondents said that they'll only scale back on holdings when their portfolios' weightings fall out of whack.
To read the complete thread or share your own insights into this topic, click here (http://news.morningstar.com/articlenet/article.aspx?id=620456).
'If a Fund Is Gonna Go Down, Sell It'
A contingent of investors said that they view flagging performance as the key--and perhaps the only--reason to sell.
Paulbrown clearly has limited patience with laggards, writing, "If a fund is no longer in the top third in its category after two to three years, it's time to consider a sale."
And Edmund_Dantes wrote, "To paraphrase Will Rodgers: 'If a fund is gonna go down, sell it. If it don't go down, don't sell it.'"
Other posters, such as jhollieb, view performance as a signal to check whether anything else is amiss. "Assuming all else is equal, underperformance of a fund or ETF relative to its category for a period of at least two years puts me on alert. I look for the reason for such underperformance and for any increases in risk."
For Proxysteve, flagging performance can be difficult to ignore. "I'd like to say that performance is not that large of a factor," this investor wrote, "but who am I kidding? The best I can say is that it is not the deciding factor."
'Hold On During the Inevitable Slumps'
Meanwhile, another contingent of posters in the thread disputed that weak performance should be a reason to sell; in fact, they view it as a buy signal.
BEmanuel admonished, "The worst time to sell a fund is when it is going down in a bad market. That is when we should be buying the fund so long as the story has not changed."
Similarly, Pauldorell is patient with laggards. "It can be a mistake to sell a fund on the basis of one or two years of subpar performance if it has a well-designed portfolio that may outperform in a longer time frame."
For MorningSun, putting up with periodic underperformance comes with the territory when investing with active managers. "In terms of performance, I give my top managers a significant amount of leash and place little emphasis on a temporary lull. Three years is really not that long, especially if one year significantly throws the numbers off the three year performance gauge. Even the best occasionally run into streaks where they significantly outperform one benchmark or another closely tied to their style and market caps. In fact, I tend to add more to those managers, especially when it looks like their strategy leads them to areas of the market that look relatively underappreciated. Based on fund flows, I think most investors are still pretty in the dark as to how recency or how one bad or blowout year can skew the numbers."
Rathgar noted that evaluating one's past sell decisions can help improve the future thought process about what to do with poorly performing active managers. "If most of us are really honest with ourselves we have probably sold when a manager was in a slump and the manager outperformed the market after we sold. I have owned and sold Dodge and Cox, Davis NY Venture (NYVTX), and Hartford Capital Appreciation (ITHAX)--all at the top this year. Also sold some of Fairholme (FAIRX). I have learned to buy good core funds with a proven investment process, and then hold on during the inevitable slumps.
'When the Story Has Changed'
Other respondents noted that they focus on fundamental factors, such as manager or strategy changes, when deciding if it's time to hit the exits.
BEmanuel summed up the case for a fundamentally driven buy-and-sell strategy. "I usually buy specific funds for specific reasons. In some cases, the reason is because there is a long-term repeatable process due to stable management. In other cases, a particular fund might fill a certain niche in my portfolio. Generally, the best time to sell a fund is when the story has changed. Either the manager has left or there has been a loss of focus or drift in style. In the case where I bought a fund to fill a niche, I might trim some off the top if that niche has grown outsized in my portfolio."
Johnep acknowledged that a fundamentally based sell strategy is, by its nature, not scientific. "When to sell is an inexact art form, at least for me. A manager change is a big red flag. I may sell the fund or at minimum watch it carefully until new manager proves their capability. If the fund changes, that is, style drift, dramatic increase in assets, or other significant factors, I will evaluate to determine if I should sell."
For MorningSun, a fund's rapidly expanding girth can be a huge red flag. "I watch asset bloat closely. Some strategies and mandates allow for significant assets. Others can get so big as to blow a manager off their core alpha contributions' effectiveness. Success breeds a lot of interest, especially as those three-, five-, and 10-year numbers start hitting. The next thing you know, a $900 million fund is suddenly an $8 billion fund. After a while, you pretty much have an expensive index with less and less opportunity for alpha. I can live with a $45 billion global multi-asset fund, but am not too keen on a $3 billion small-cap fund."
SkepticalG noted that selling a fat fund can be difficult, particularly if you were around during its better years. "It's tough when funds lose that advantage often referred to as being nimble," this poster wrote, "It is indeed tough to leave a fund that has helped you prosper and then go separate ways."
'I Place High Importance on Managers'
Of the respondents who said they focus on fundamental factors when determining whether to sell, manager changes were most frequently mentioned as a red flag.
RGWelch advised, "Remember for mutual fund investors, you are typically 'hiring' a group of people to make your investment decisions for you. Make sure the group you hired is still there. Otherwise you may be paying management fees to someone who does not have the skills you thought you were purchasing."
Many posters agreed that management matters more for some funds than others. MorningSun wrote, "I place high importance on managers, especially those with broad mandates or the liberal use of derivative instruments. If a key member departs or arrives, I'm very watchful. If that key departure carries a chief investment officer or co-chief investment officer title, I'm out."
For Yogibearbull, manager changes are the most worrisome if the manager's skill was a key driver of the original fund purchase. "If I go into a fund because of its manager, and there is a change in that manager, I sell. Examples included Fidelity Magellan (FMAGX) (when Peter Lynch retired), Vanguard Windsor (VWNDX) (when John Neff retired), Vanguard Growth Equity (VGEQX) (when Turner [Management] was fired at a bad time). For my current holdings, this includes watching Loomis Sayles Bond (LSBDX) (with Dan Fuss), PIMCO All Asset All Authority (PAUAX) (with Rob Arnott), Templeton Global Income (GIM) (with Michael Hasenstab), and so on. For other funds [without notable managers] that I own, I just put them on watch if there is a manager change."
Other posters agreed that manager changes call for extra watchfulness, but selling without a full evaluation can be a mistake. Tonyg34 believes a strategy shift--rather than a manager change--is more concerning. "I sold out my position in MainStay ICAP International (ICEUX) after manager Rob Lyon passed away unexpectedly. That proved to be a mistake. A good system is transferable from one manager to the next. Only sell a fund when they abandon their principles; even well-run funds like
Longleaf Partners (LLPFX) will lag the market from time to time."
FidlStix agreed that a manager change is most worrisome when its accompanied by a strategy shift. "If a prominent or lead manager leaves, red alert! I watch the fund's holdings carefully to see if the new regime starts making wholesale changes."
Carrie noted that staying attuned to strategy changes has served her well. "Back in the 1990s, I owned Janus (JANSX). It was, when I bought it, a pretty stodgy large-cap fund. Then the Internet bubble hit, and after lagging for a while, Janus Fund jumped on the bandwagon. Since I didn't want to own an aggressive tech fund, I sold it. The fund had changed its investment strategy; it wasn't the the stodgy fund I intended to purchase, and it wasn't a fund I wanted in my portfolio at that time."
'It Goes on a Watchlist'
Many posters said they consider myriad factors when deciding whether to sell, with performance, fundamental factors like manager changes, and a fund's role in the investor's portfolio all playing a role. A frequently cited strategy was to use deteriorating performance as a signal to conduct due diligence on the fundamentals.
Dtconroe summarized that approach: "If the comparative fund performance appears to be deteriorating due to loss of proven managers, failure of the fund to close to protect investors, change in fund characteristics such as unacceptable asset growth, changes in portfolio objectives, and so on. Then it goes on a watchlist until it demonstrates the capability of managing a negative that could lead to that deterioration."
Deltadave's criteria are primarily performance-focused--factoring in both a fund's risk metrics and returns--but he also tunes into fundamental factors like manager tenure and bond portfolio duration (a measure of interest-rate sensitivity). Holydoc, too, considers a variety of different factors--performance, portfolio characteristics, and fundamental issues like manager changes.
Because staying on top of all of those factors can be complicated and time-consuming, several posters said they look to professional ratings organizations to help guide the decision-making. Coolspree wrote, "Since I'm not an expert I consult the experts. There are several websites (Morningstar.com, Bar Chart and Stoxline are just three of them) where I periodically enter my holdings in to see what they say. I know it is not very professional but then again, the advice comes from the professionals. This method has earned me quite a comfortable profit over the last several years."
Other posters concurred that they might bump a fund if they find something they like better. Solyom shared, "I remember John Templeton saying that he holds on to a stock until he finds something a lot better. If and when I find something a lot better I will switch."
'Meeting My Allocation Objectives'
Other posters said that they pay keen attention to the holding's fit within their own portfolios.
Chief K sells when "the fund I'm selling has had several years (more than three) of below average performance for its category and/or there is a Vanguard Index fund that that is a good match (and of course is less expensive), and/or I have decided to reduce, or to eliminate, that category of investment from my asset allocation."
Darwinian is almost exclusively more tuned into his own portfolio's allocations when deciding whether to sell, "Usually I sell down a fund only because it outgrows its slot in my asset allocation."
Maintaining a desired asset-allocation mix while keeping a slim list of investments are top-of-mind for MBAFBA, who wrote, "I sell (and buy) to rebalance, at which time I review my portfolio to determine the best candidates to get rid of and to see if there are some to add to. One of my overall objectives is to keep my portfolio to as small a number of funds as I can while meeting my allocation objectives."
Taylor Larimore wrote that index-fund investors don't have to worry about manager or strategy changes; they can instead focus on individual portfolio considerations to drive their selling decisions. "We stay the course with our index funds knowing that they will never underperform the market (less worry)," this Boglehead guru wrote, "We only sell for tax-loss harvesting, rebalancing, and withdrawal of shares for living expenses."
Taylor wasn't alone in mentioning tax considerations. Pauldorell wrote that he tends to be a more active seller in his tax-sheltered accounts. "Another factor that affects my selling is whether the fund is in a taxable account or an IRA. Since there are no tax consequences for sales in IRAs, I tend to make more changes there."
On the flip side, Dragonpat is often on the lookout for tax-loss harvesting opportunities and therefore may be more inclined to sell laggard holdings in her taxable accounts. "If I have a tax bill coming up that can be helped from harvesting capital losses, I'll harvest the loss maybe when [the fund] is down 10%, but 20% is more typical. I have more than once waited 31 days and rebought the same fund to avoid the Internal Revenue Service wash rule."