Sometimes it's just hard to let go. But although separation anxiety comes with the turf, it also pays to know when to cut an investment loose. For investors who got burned in the mutual fund market last year, this can be a hard pill to swallow now that their holdings are finally showing signs of life and the promise lingers that they can recoup losses. "Sometimes there's that tendency to want to claw your way back," says Christine Benz, Morningstar's director of personal finance. "It's kind of a psychological hurdle." With that in mind, here are some tips from Benz and other experts about when to dump a fund:
Pay attention to up-market performance. While few mutual funds, regardless of style or sector, emerged unscathed from 2008, defensive managers tended to lose less during the worst of the bear market. But now that funds are rebounding, it's worthwhile to make sure that the ones you own have what it takes to capitalize on turnarounds. "There are some managers out there who tend to do very well when the market is doing poorly and tend to do very poorly when the market is doing well," says Adam Bold, the founder of the Mutual Fund Store, an investment management firm with 65 U.S. locations. Bold suggests looking at how your funds have performed since March 9, 2009, when the market hit its low.
In the end, though, it's all about balance. "I would say maybe that's one of the few silver linings of the bear market—that 2008 compared with 2009's first half gives you a good lens through which to view fund performance," Benz says. "It has been a real opportunity to witness both extremes."
Management matters. The shake-up of the financial sector has caused a number of changes in fund management, as shifts at the fund company trickle down to individual funds. "Their parent companies have been through a lot, and one thing we're keeping an eye on is what changes in personnel have resulted," Benz says. Putnam Investments, for example, has experienced a high rate of manager turnover in the past few years, most recently after it was bought in 2007 by the Canadian company Power Financial Corp. If your fund has a new manager, take a close look at the manager's goals to make sure that they align with yours. "Human nature being what it is, a manager that takes over a portfolio is going to want to make a mark," says John Bonnanzio, the group editor of the newsletter Fidelity Insight.
Be wary of unsustainable returns. Sometimes the funds that grow the fastest are the ones that fall the hardest. If your fund is experiencing uncharacteristically high returns that don't look sustainable, knowing when to take your winnings and run is a must. "That's a hard thing to do because it runs almost counter to human nature," Bonnanzio says. "People tend not to sell funds when they're moving higher, and all too often they fall off the cliff with them."
Take, for instance, Fidelity's Spartan Long-Term Treasury Index (symbol FLBAX). Bonnanzio's newsletter downgraded the fund in late 2008 because he thinks its rapid growth, fueled in part by U.S. treasuries, had reached its peak. Says Bonnanzio: "The market is very good at sending signals about things that are either overbought or oversold." It's just up to you to listen.
Don't pay more than you need to. Funds sometimes raise their expense ratios—or annual fees—to compensate for shrinking assets, as happened when investments declined and investors pulled money out of the stock market in 2008. Still, you might consider jumping ship if the cost is too high. Morningstar, for example, removed Century Small Cap Select (CSMVX) from its Fund Analyst Picks, citing soaring fees.
Don't pay up for poor performance. You shouldn't necessarily flee every time a fund raises its expenses, but it's important to find out why costs are going up. Morningstar research suggests that fee increases are a solid indicator that a fund is having some institutional difficulties that could also have a downstream impact on performance. Meanwhile, if you're in a taxable account, it may be a good move to put your losses from the recession to use. To do that, you can switch funds and book a tax loss, which can offset future capital gains payments.
Bounce back. If you've been looking to get rid of a fund for a while but couldn't bear to write off all the losses, make the most of the recent upswing in the market. "If you have any of those investments that maybe you don't think are great long-term investments but have enjoyed a nice bounce lately, it could be an impetus to maybe give them the heave-ho," Benz says.
Don't panic. Not every tremor is an earthquake. Re-evaluating your portfolio is a good idea, but don't get too spooked by funds' 2008 performance. "People are listening to [reports] and making emotional decisions rather than intellectual decisions," Bold says. "We expect things quickly in our society. But investing is the kind of thing that takes years. The get-rich-quick stuff—it doesn't work very often." Bold recommends giving good managers who have had a bad year some leeway. "I can't make my long-term plans based on catastrophic events that you or I can't imagine," he says.
Be flexible. Guidelines are useful but should be taken with a grain of salt. "I think that the first rule that has to be noted is that when it comes to buying or selling any actively managed fund, all rules are meant to be broken," Bonnanzio says. "That's the thing that makes this business fun."