Make Your Funds Stand for Election

Election day creates a special burden for financial writers. Many feel they must tell you how certain stocks or funds will react to the outcome of the voting. However, with so many variables affecting market performance, I find such predictions difficult--if not impossible--to make with any hope of accuracy. Rather, I'd like to expand upon an idea I first explored a year ago when California staged its memorable recall vote. That idea is to treat your funds as if they're incumbents seeking re-election--with other potential fund choices as the opposition candidates seeking to replace them.

Surprisingly enough, in important and meaningful ways the process political candidates must follow resembles that of building and maintaining an effective investment portfolio. In fact, keeping those similarities in mind can help you maintain a disciplined approach and ensure you own an appropriate collection of investments.

A Democracy, Not a Dictatorship
Start by thinking of your funds as a collection of political leaders who had faced off against competitors and convinced the voter--in this case, you--that they were the best choices for their positions in your portfolio. Though not ideal in every respect, they persuaded you that among the available choices, they were the ones most likely to address your particular needs.

All too often, though, once a fund wins a place in a portfolio, it tends to keep it forever, whether or not it deserves that honor. That's where the election motif can impart a necessary discipline. In a democracy, candidates must stand for election at regular intervals. You don't want any self-appointed dictators or presidents-for-life in your portfolio. So on a regular basis, force your incumbents to face the electorate and prove that they deserve to keep their jobs.

The Primaries
In order to have a point of comparison for the funds already in your portfolio, you need to find some promising candidates to challenge them. Look for impressive large-growth funds to challenge your current large-growth holding, for example. As in a political primary, some fund candidates might land a spot on this preliminary list just because they have recognizable names; others might be intriguing fringe candidates, perhaps unlikely to win but at least worth a cursory look.

Using the techniques we've discussed often on Morningstar.com, winnow this field down to just one or two challengers--those that will provide the strongest competition for your incumbent. Then let the debates begin.

The Debates
Now that you've got your challengers and incumbent lined up, put them through a process similar to the election debates. In this case, you're the one asking the questions--and in your debate format, you don't allow one fund to badmouth the other. First, force your incumbent to defend its record. As with real political candidates, keep in mind the circumstances that the fund had to navigate. And as you would for a governor, senator, or president, ask if the fund kept the promises it made on the campaign trail. Did the fund stick to its mandate or veer in unexpected directions? Did it perform as one would expect given the conditions in the economy and the market? And don't forget the budget questions: Has this fund spent too much? Did its expense ratio rise for no good reason?

Then turn to the competitor. Set the bar high, especially in taxable accounts and for load funds, where there can be costs associated with switching funds. Question the competitor's record. For example, as an incumbent might point out in a political debate, consider whether the challenger just looks good because it hasn't been in office very long. For example, maybe a young, promising fund boasts an impressive record so far, but it didn't have to face the tough decisions in the roaring rally of 1999 and the sudden crash of 2000.

As the moderator of these debates, you can also go beyond the obvious issues to bring up some less common, but still relevant, ones. Which manager is more forthright in his quarterly or semiannual commentaries? Which fund makes you feel more like an owner and less just an anonymous customer? As in a political election, in a close race with two strong candidates, sometimes the less dramatic issues can tip the scales.

Waving the Red, White, and Blue
One of the most common elements of just about any political campaign is the injection of patriotism into the race. Bumper stickers are inevitably red, white, and blue. American flags flutter behind the podium at every event. Speeches routinely contain glowing praise of our country's history and values.

Interestingly, many mutual funds also wrap themselves in the flag. How else to explain fund companies with names such as American Funds, American Century, First American, and First Eagle? Or that our nation's Founding Fathers have apparently become quite enthusiastic about mutual funds? Ben Franklin has a fund family and so does John Hancock. A third firm's logo features none other than George Washington.

Such efforts do no harm. But in investing as in politics, it is important to look beyond the patriotic veneer and base your decision on the more substantive issues at hand.

Good News: You Can Vote Twice
Finally, one important distinction between investing and voting. If you find that you like your incumbent so much you want to keep it, and yet you also find the challenger compelling, you can vote for both. Don't do that too often, though, or you'll end up with a bloated and redundant portfolio that can be too unwieldy to monitor properly. But feel free to occasionally add an outstanding fund with a great manager even if you already own one in the same general category. If both funds have managers that are truly topnotch, original thinkers, their portfolios may not even have many issues in common.

Most of the time, though, it is better to choose one and set the other aside. After all, the loser can always mount another challenge at the next election--which, as in politics, is never too far away.