Note: This video is part of Morningstar's January 2015 5-Point Retirement Portfolio Checkup special report.
Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar data shows that fund investors often mistime their purchases and sales of mutual funds, but there are good reasons to sell a fund. Here to offer some tips is Morningstar's director of personal finance, Christine Benz.
Christine, thanks for joining me.
Christine Benz: Jason, it's great to be here.
Stipp: This week, we are talking about doing a portfolio checkup. A lot of our users are doing those in January, and you might find some funds that you think aren't doing what they should be doing. You might be considering a sale of that fund. Do you have some tips, though, to help really put that into the right context?
I think the first thing that folks will look at and wonder about a fund is performance. It looks like the fund underperformed. When is performance a good reason to sell a fund?
Benz: Well, I think if you are evaluating performance, you want to make sure that you are viewing it through the right lens. So, certainly, don't compare every fund in your portfolio to your best-performing holding. You need to make sure that you have the right benchmark to evaluate it. This can be either the fund's category peers--and, of course, Morningstar places funds in specific categories--or maybe better yet, an inexpensive index fund or exchange-traded fund. And that tends to be a somewhat higher hurdle in many categories, just a good core-type index product that's in that same category.
So, compare your performance, and you want to focus on performance over a full market cycle. Don't just focus on this period from 2009-14 where we've had relatively strong performance. Take a look back to a period that encompasses more volatile times. You want to look at how your fund held up in 2008 and consider that. So, consider volatility, certainly, as a part of your evaluation as well as its returns over a given period. You can look at standard deviation to gauge volatility. You can find a fund's volatility relative to its category peers, relative to an index. That's information that we provide on Morningstar.com. Or you can do a gut check: Look at performance, look back to 2008, look back to 2011--not quite as bad a year, but also a volatile year--to see how it did in those two years as well.
Stipp: So, you're going to want to look for a good benchmark--make sure you're comparing performance with the right thing--and also a longer time period. So, sustained underperformance over many different market cycles might indicate the fund hasn't been doing well. And you also say to pay attention to the role this fund is playing in your portfolio as you are assessing performance.
Benz: I think the point is to look at the role the fund is fulfilling for you. So, say you own a dividend-focused fund, maybe a dividend-growth fund like Vanguard Dividend Growth (VDIGX), and you want to think about why you hold this fund. [You might say,] "I hold it to be a core equity position; I hold it because I expect its volatility to be lower than the broad market." So, you want to think about the role that the particular fund fulfils in your portfolio. For some investors, if it's a more volatile holding but they really want it to be the type of fund that steps up and performs well in a bull market, you want to make sure that it has delivered over a bull-market time frame. So, do think about the context within your own portfolio when gauging its performance.
Stipp: The second big category of things you'll want to consider as you are thinking about whether to keep or sell a fund is fundamental changes at the fund manager itself--so, the fund's operations. What are some things you should check there?
Benz: A fund-management change would certainly be a catalyst to review the fund and whether it's still a fit for your portfolio. I don't think a portfolio-manager change is automatically a catalyst for a sale, but it does mean that you should get in there and you should understand what the manager's previous experience has been, whether he or she has had any previous involvement with this particular fund or this particular investment style. And at that point, you also want to take note of whether the new manager will change things up because he or she has used a different strategy at a previous charge perhaps. I do think that if you are looking at a fund where it has a manager change and the new manager has no previous track record that you can evaluate, that to me is a red flag. That is potentially a catalyst for a sale, but you do want to be nuanced in your evaluation if the manager does have a previous track record elsewhere.
Stipp: And I think if the manager has run a certain style--like a concentrated style--and that manager leaves, that could be a good reason to really reassess a fund.
Benz: Absolutely. So, the more specific the investment style is--say, if Bill Nygren left Oakmark Select (OAKLX) and the new manager did not have any experience running a concentrated fund, that would be a red flag for us.
Stipp: So, if the manager has a lot of leeway, does a lot of stock-picking, it might be hard to replace that kind of strategy.
Stipp: Something else to keep in mind as well is how big the fund is getting, because if a fund gets too big, that can have an effect on future performance.
Benz: It can. And this is mainly a concern if the fund traffics in some sort of less-liquid security type; maybe it's small-cap or even micro-cap stocks. If you see the fund getting larger and larger, that's a reason to pay attention because that could begin to dilute performance or at least change the investment strategy in play. The manager may just buy more holdings that are small- and micro-caps, or he or she may start to graduate into larger companies. That changes the fund's strategy, and that may change the role that it plays in your portfolio. You may not want that particular fund in your portfolio anymore.
The thing that I would point out, though, about asset bloat is that usually when we see funds that have grown too large, they don't become terrible. They don't suddenly become bottom-decile performers. What we tend to see is more or less a slow drift into mediocrity, where we start seeing a lot of returns that fall between the 40th and 60th percentiles. Not terrible, but maybe not quite as great as the fund's performance was when it was more nimble.
Stipp: Something else you need to pay attention to is not just the assets under management at this fund but other assets that the manager might be managing in the same strategy, because sometimes they are managing other funds or separate accounts with a lot more money than you just see in that fund itself.
Benz: That's a great point. So, even though your fund might appear relatively svelte, the manager may be running other products that use that same investment strategy, and he or she may be having to put money to work in more companies of that style than is readily apparent. So, do pay attention to that. That's information that you can find on Morningstar.com. You can also dig into a fund's statement of additional information to find some details about the total assets the manager is running in a given style. That's a great piece of advice.
Stipp: And then what about the fund family itself? If there are signs of changes or upheaval, if a lot of turnover is happening at funds--maybe even if your fund itself isn't affected--how should you account for fund-family issues that may be cropping up?
Benz: This is certainly more art than science, but if you are invested with a fund and a family where you have started to see this exodus of long-tenured managers, for example--you're right--even if your particular fund manager is still staying onboard, there might be something else going on at the firm that is worth paying attention to. Maybe you own a fund run by a boutique fund manager and that firm got gobbled up by some larger entity; now, the managers are having to spend a lot more time on marketing and distribution than perhaps they did in the past.
These are softer factors, definitely tough to evaluate. Certainly, I would say, if you have a fund where performance looks OK, no change to the strategy, no change to your manager, there is probably no need to be pre-emptive. But I would certainly say this whole category of fund-company changes and stewardship, which we evaluate through our parent grade, is worth plugging into if you are a fund investor deciding what to do with a fund.
Stipp: So, we talked about fund fundamentals. We talked about fund performance. Let's say both of those look solid, but the third big thing you should think about are changes that happen to you, the investor. And maybe this fund isn't a great fit for you anymore.
Benz: That's right. A great example is if you have held a given fund to fulfil a given goal, and then you get there. So, maybe you held a balanced fund to help you save up for a down payment for a house, and then the time comes when you have met that goal--you've saved as much as you hoped to. You need to kind of batten down hatches, maybe transfer the money to cash so that it's there when you're ready to actually buy. So, if you've hit a goal, that can be a reason to re-evaluate the fund and its purpose in your portfolio.
Stipp: And over time, you might also similarly have need to de-risk a long-term portfolio and take maybe some of your equity exposure off the table.
Benz: That's right. So, I think it's also worth thinking about your own personal behavior with your holdings. If you've reflected on your trading patterns over the past decade, for example, and say, "Well, I've held these very volatile investments in my portfolio, but I've tended not to time my purchases and sales well." I'm just going to kind of take some risk out of this total portfolio. I am going to get rid of some of those narrowly focused sector-specific funds, or maybe I don't need any high-yield-bond exposure in my portfolio--the equity piece does that just fine. So, de-risking that total portfolio, I think, is a sensible catalyst for a sale as well.
Stipp: You might also find that this fund has a lot of overlap with another fund that you have. So, duplicates, I would imagine, could be a good reason to streamline?
Benz: Streamlining is always a great reason to think about selling. You might have holdings that do sort of occupy the same slot within your portfolio. You might want to do a head-to-head comparison to decide which of those is actually the better holding. Lightening up your overall number of positions is a worthy goal for investors really at any life stage.
Stipp: And for folks investing in taxable accounts, they should keep an eye on tax efficiency because they might be paying more in taxes than they need do.
Benz: This is top of mind for a lot of investors right now who, if they had actively managed funds in particular, many of those investors got socked with big capital gains distributions in 2014. Looking at your taxable portfolio with an eye toward making it just as tax-efficient as it can be is a worthy goal. For equity exposure, individual stocks, exchange-traded funds, tax-managed funds will tend to be a more tax-efficient choice over time than will actively managed funds. And certainly, if you have bonds in your taxable portfolio, you want to look at the appropriateness of municipal bonds versus bonds and bond funds that will be taxed at your ordinary income tax rate.
Stipp: Here at Morningstar, we're buy-and-hold investors, but there are good reasons to sell a fund. Thanks for joining me with these tips, Christine.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.