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By Christine Benz and Sonya Morris, CFA | 02-21-2013 09:00 AM

When to Sell an Active Fund

Strategy changes, poor stewardship, and asset bloat are among the many possible red flags that shareholders of actively managed funds should recognize to know whether to sell or stay invested.

Christine Benz: Hi, I'm Christine Benz for I recently attended the Morningstar Ibbotson Conference, where [Morningstar senior investment consultant] Sonya Morris talked about how to select active fund managers. I had the chance to sit down with Sonya to talk about how to know when to sell a fund.

Sonya, thank you so much for being here.

Sonya Morris: Thank you, Christine for having me.

Benz: One of your key jobs in your role at Morningstar is to select and monitor fund managers, and you do this for a living. So I’d like to get your guidance, Sonya, for our users what should they think of a sell triggers when deciding whether to sell a fund. We recently had a discussion with our users in our Discuss forums, and it seemed like there is a lot of confusion about this issue. Readers said that they had sold funds that they later regretted selling or maybe they had held on to funds too long. So I'm wondering if you can kind of talk about how you think about selling, when do you make that decision whether to sell.

Morris: Sure. Well, I think really the key is to have appropriate expectations at the outset. So whenever we select a manager for a portfolio or for a Morningstar Select list, we write down why we chose it, the role we expect it to play in the portfolio, and also what our expectations are around performance. If any of those expectations are not met for one reason or another, that's a trigger to us to do a closer look at the fund and possibly consider replacing it.

Benz: So you mentioned performance and setting expectations for performance. How do you do that? You don't know what the market will do. You don't know how a fund will perform in specific environments. How do you go about setting those performance expectations?

Morris: Well, before we select a fund, we look at performance from as many possible angles as we can. So we’ll look at performance during uptrends, during downtrends. We’ll look over rolling periods. We'll look at risk metrics, like upside capture ratio, downside capture ratio, and max drawdown--anything we can to give us information to help us set some sort of framework about what to expect going forward. So our goal is to have expectations about how a fund might perform in a variety of market conditions.

Benz: If you bought a fund specifically for its defensive characteristics, thinking it would be a good downside performer, would it be a red flag if you saw that it went on to lose a lot more than its peers in the down market?

Morris: Exactly. If we owned a fund like that, and it didn’t outperform in 2008, that would be an extreme disappointment to us, and we’d want to understand at the very least why that happened.

Benz: You wouldn't necessarily kick it out, but it's a reason to do some further digging.

Morris: Exactly.

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