Mutual Funds Are Not Buy-and-Forget Investments

Long-term investments still need tending.


Many people believe that they can reach their investment goals by simply buying mutual funds. After all, investing in a group of funds that hold different kinds of stocks, bonds, and commodities is supposed to provide diversification, which can give some protection when the markets are down and better returns when prices rise. That's not necessarily true. All funds aren't created equal; some are better than others. Investors have to pay attention to all of the funds in their portfolio regularly, because even good funds can go bad.

It's not easy to distinguish the good funds from the bad ones. The main things to consider are the fund manager and performance. You've heard the disclaimer that's on every investment product: "Past performance does not guarantee future results." Don't listen to that. In my view, past performance—that is, the fund manager's past performance—is the most important factor when deciding to buy a fund. Reviewing a fund manager's performance over different time periods gives an idea how that fund behaves in various market environments.

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It's a lot like baseball. The New York Yankees, which has many of the top players in the league, won the World Series in 2009. This year, the team won enough to make it to the American League Championship Series, but didn't beat the Texas Rangers to advance to the World Series. Similarly, if a fund manager can navigate the trends in the market over different time periods and holds the right securities, there's a good shot that it will be a superior performer. Check a fund's performance over one-, three-, five- and 10-year time frames. If a fund manager has been in the top 20 percent of all funds in those periods, she or he is a consistent winner.

However, some star fund managers can't keep up with changing markets. For example, Bill Miller at Legg Mason Capital Management Value fund (LMVTX) has struggled after beating the S&P 500 index for 15 years from 1991 to 2005. There's no reason to hang on to a fund that has lost its luster. You're not married to that fund manager. There are plenty of other funds that may provide better returns.

To avoid hanging on to losing funds too long, check the funds you own every quarter. You should sell a fund if the reasons you bought it have changed, such as the manager has left, or you have simply found a better fund.

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Some people won't sell a fund because they don't want to pay taxes. That's not a reason to stick with a fund. Let's say you invested $10,000 in a large-cap value fund in April, and the market struggles over the next several months, so by November your investment hasn't budged. The fund company's website says it expects a 15 percent capital gains distribution (usually paid in December). If you don't sell the fund before the "shareholder-of-record" date for distributions, you'll receive a 1099 form from the fund company obligating you to pay taxes on that $1,500 distribution, even though you didn't enjoy any gains. You're better off selling the fund at a loss before the record date of distribution in early December to avoid the tax hit. Then, move the investment to another fund that won't have a large distribution. (If you need more help with tax-efficient investing strategies, ask a financial adviser or accountant.)

Another reason some investors put off dumping a fund is that some funds have back-end loads (deferred sales charges). If your fund has risen 5 percent while another fund with similar risk has gone up 10 percent, you're losing the opportunity to make more money. If you do have an underperformer, it can make good sense to sell it and pay the back-end load so that you can move on to better funds. When you forget your funds, you risk missing better investments and the potential for more money.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April, 2009). He is Chief Investment Officer of The Mutual Fund Research Center, an SEC registered investment adviser which provides mutual fund and asset allocation recommendations and research to stores in The Mutual Fund Store system.