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Eight Ways to Tell If You Should Hold or Fold Your Mutual Fund Investment

InvestorEducation / Learning to Invest Jun 08, 2010 - 05:39 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleLarry D. Spears writes: With the whipsaw patterns U.S. stocks have experienced in recent weeks - both the Dow Jones Industrial Average and Standard & Poor's 500 Index are down 12% from their highs for the year - even the most ardent buy-and-hold investors are studying their portfolios, searching for holdings to cull.

But what if your buy-and-hold strategy has been implemented using mutual funds? As part of a solid "defensive-investing" review, should you consider bailing out of your current mutual-fund holdings at this point and start looking for better funds to ride into any future recovery?

You'll only know if you take the time to make the review. And you should take that time.
In this two-part story - this is Part II - we examine the eight questions to ask yourself as you attempt to determine whether your mutual fund still fits you - or whether it's time to move in another direction. Part I appeared yesterday (Monday).

Here are the remaining questions mutual-fund investors need to ask:

4. Has the performance disparity upset your portfolio balance? Over time, economic conditions and differences in the performance of various market sectors - and the funds in your portfolio that track them - can cause asset-allocation percentages to diverge from your desired levels. For example, a couple of big winners by your speculative fund manager might put 20% of your assets in that category, rather than the 10% you want - leaving a smaller proportion for other categories, such as income.

Dealing with this situation - and preventing it from getting worse (further out of balance) - demands that you adjust your holdings on a periodic basis, a process known as rebalancing. If you have just one fund in an "over-weighted" segment of your portfolio, you would sell some of your shares and reinvest the proceeds in existing or new funds in a different, currently "under-weighted" category. If you have more than one fund in a sector that has become over-weighted, sell the weakest performer in the group.

When should you do this rebalancing? There are several schools of thought. Some advisors suggest following a regular schedule - say, every 18 months to two years, if needed - while others suggest doing it after the market has experienced major rallies or after specific sectors have pushed the weightings in some categories to new highs.

Whichever approach you choose, be sure to factor tax consequences into the equation; having to pay too much to Uncle Sam - or having to pay that extra levy at the wrong time - could negate the benefits of rebalancing.

5. Are your fund's fees going up? Mutual funds are generally considered longer-term investments and, over time, even small increases in fund fees and expenses can eat away at your long-term returns.

Fee increases can result from numerous factors. Sometimes, it's simple greed by the fund managers. Other times, it can signal a drop in operating efficiency. Rising expense ratios can also be the result of excess redemptions, with a fund raising annual fees because it has to spread its expenses out over fewer shareholders. This was responsible for a huge wave of fund-fee hikes after investors bailed out of the stock market in late 2008 and early 2009.

Whatever the cause, fund fees have trended higher in recent years. According to (Nasdaq: MORN), today's average annual fund expense fee is 1.34% of assets. That's down slightly from 1.38% in 2000, but well above the Morningstar estimate of 1.18% for 1990.

All funds charge fees - even those, such as index funds, that aren't actively managed. So you shouldn't automatically sell when a fund increases its expenses, especially if the fund company offers a reasonable justification. By the same token, you shouldn't pay more for less performance. If fees are going up and returns are going down, look for a lower-cost fund in the same sector.

The same applies to sales charges. Paying a high "load" without a good reason makes little sense given the number of no-load funds out there that perform well for less - and often with greater efficiency.

6. Are you happy with the fund's manager? When you place your money into a mutual fund, you're putting a certain amount of faith in the manager's expertise and knowledge - talents you hope will lead to an outstanding return on an investment that fits your investment goals. If the fund performs well, the manager generally gets your praise - and, if it doesn't, he or she gets the blame (deserved or not).

However, evaluating portfolio managers isn't quite that simple. Some do very well when the market is suffering, then lag when the market turns higher. Others outperform on bullish moves, but slide to the bottom of the rankings in downturns. A very few outperform in up and down markets alike.

In the end, what most investors prefer is a manager who can achieve a balance over time - maybe not the best in good times and certainly not the worst in bad. What very few want to see is a change in their fund's manager.

As already noted, some managers leave on their own job, riding your fund's success to new opportunities. Others get the boot, usually due to poor performance. Either way, a change in managers will likely lead to at least modest changes in the fund's style and in its results; after all, the new manager will want to "make his own mark" with the fund.

Just as two to three years of patience may be needed for a good fund gone bad to recover, you should resist the urge to immediately leave a fund just because of a change in managers. It typically takes at least six months for a new manager to restructure his predecessor's portfolio. So you probably needn't worry about a further dip in returns before that. At the same time, however, you can't expect to see an immediate improvement in results.

How long you give a new manager to prove himself after that depends on his past performance - which the fund will publicize when the appointment is made - and his early results in this new job. If both are good, hold your shares for a year or two; if either makes you nervous, switch sooner.

7. Are you familiar with the fund's board - and do you approve of the board members' actions? Most investors know about the individual or team that manages their fund's portfolio, and they're familiar with the management firm that runs their fund's "family" and sells its shares. What many investors don't realize is that both must answer to the fund's Board of Trustees, which is legally responsible for evaluating fund performance, hiring and firing managers and setting shareholder fees.

That fact got major attention in late March, when the U.S. Supreme Court ruled (in Jones v. Harris Associates) that fund managers can continue to set fees according to past standards, but must provide justification to the boards of trustees whenever fees charged to retail fund customers are higher than those assessed to institutional clients.

Recent studies had indicated fees for retail-fund shareholders are often double those of institutions, which has led critics of the fund-management system to charge that boards of trustees aren't doing their jobs. The critics cite close ties between trustees and fund operators, the fact that some boards oversee dozens - or, in some cases, even hundreds - of funds, and that boards rarely fire fund managers, even when the fund's performance is dreadful.

The ruling sparked much discussion at the national meeting of mutual fund executives in Washington in early May, with some observers predicting that trustees will:

•Be pressured into conducting much stricter oversight of fund operations.
•Be more closely reviewing managers' relationships with institutional clients.
•Eventually have to mandate lower fees.
"They're not going to want to get sued," Ben Phillips, a partner and the director of research for management-consulting firm Casey Quirk & Associates LLC, told

Others didn't see the ruling leading to major changes, noting that U.S. mutual fund fees are already among the lowest in the world.

"The ruling seems to presume directors have never looked at differential fees in the past, and that's not the case," Bruce Crockett, chairman of the board that oversees the Invesco Ltd. (NYSE: IVZ) family of funds, told FoxBusiness. "I don't see how this [the ruling] changes much."

Crockett doesn't see a big increase in the number of portfolio managers being fired by trustees for poor performance, calling the replacement of a manager "a nuclear option."
One way some companies ensure directors closely watch out for shareholder interests is to require board members to invest in the funds they govern, but a recent survey of America's largest fund companies found that most merely encourage directors to own shares rather than requiring it.

There's also a move afoot to get the U.S. Securities and Exchange Commission to change its rule regarding independent oversight of fund operations. The current rules require 40% of a fund board's seats to be held by independent directors, but a change would apparently have little impact since a survey last year found that independent directors already make up three-quarters of fund boards in nearly 90% of fund companies. Almost two-thirds of fund companies also have boards with independent chairpersons.

As an individual shareholder, you really have no easy way to determine how strongly your fund's board stands up for your rights. But if the fund shows a recent trend toward rising fees coupled with marginal performance, something's likely amiss with the fund's oversight and you may want to consider a switch.

8. Do your funds continue to meet your goals? When you're just getting started in the investment world, mutual funds serve a valuable purpose, providing you with a level of diversification and access to securities and asset classes you otherwise couldn't afford. But as you gain experience and acquire more wealth, you may prefer to invest directly and manage your own portfolio. If you're moving into that phase in your investment career, that alone may be reason enough to start moving out of funds.

Similarly, as you age, your life goals change, and that - more than performance - can prompt a "Sell" decision. Do you need cash for a child's college, a new house, or some other purpose? Do you need income for retirement rather than growth? Are you becoming more conservative and feel you can no longer handle the volatility of high-tech or other speculative funds? Does your current tax situation make selling more affordable at this time?

Any change in your investment or life goals is a good time to consider a mutual fund sale - and only you can provide the answers to the many possible questions involved in your decision.

This article provides a lot of useful guidelines, but you have to tailor them to your own situation - and adjust them as needed.

As John Bonnanzio, group editor of the newsletter "Fidelity Insight," often says: "I think the first rule ... when it comes to buying or selling any actively managed fund, [is that] all rules are meant to be broken."

Which leads to one final tip: If you know you don't have the patience to give new managers a chance, endure occasional poor returns and wait two or three years for good funds to recover, you may want to sell all of your actively managed funds. You may get better results - and sleep more soundly - by relying on index funds.

[Editors' Note: For a sidebar on this story that appears elsewhere in today's issue of Money Morning, please click here. For other stories in Money Morning's "Defensive Investing" series, please click here.]


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