Do You Have a Problem Child in Your Portfolio?

Dividend-paying stocks and funds topped Morningstar.com investors' lists when I polled you for your highest-conviction holdings last week;  Vanguard Wellington (VWELX) took top honors as the most frequently mentioned investment Morningstar.com investors would like to hold forever.

But what about the flip side--those investments that keep you up at night? I asked posters in the HandsOn forum of Morningstar.com's Discuss boards to share their problem children, and the responses poured in. Bonds were a key area of worry for several posters, with the threat of rising interest rates looming large; other posters noted the difficulty of wringing any sort of yield from their cash-type holdings given where rates are now. Stocks and stock funds were top-of-mind for other posters: Hard-hit international funds had caused angst for some participants in the thread (looking at you,  Janus Overseas (JAOSX)), while other posters noted that beaten-down value funds had them wrestling with whether to hang on or sell.

Finally, posters wrangled over whether putting up with periodically struggling investments is a necessary evil or whether investors should take a zero-tolerance policy toward investments that detract from one's peace of mind.

To read the complete thread, or chime in with your own problematic investments, click here.

Bonds: 'The Wall of Worry'
The thread focused on many individual securities. But if there was one asset class that posters pointed to as their most vexing it was bonds, hands down.

Dougdorite promptly replied to my query about problem children in the portfolio with this post: "Bond funds, bond funds, bond funds. Are they destined to just go down as interest rates (eventually) rise? Even though [my holdings] are intermediate-term funds and Vanguard Total Bond Market Index (VBMFX), I worry about these the most."

Ramble165 agreed that they happy days for bonds could be drawing to a close. "Like one of the others, I worry about when to get out of bond funds. They are a primary source of monthly income and have performed very well but the party may be about over. I'm tending to move more toward the bucket approach." (This article details the bucket approach to managing a portfolio during retirement.)

Dknesper worries about how the prospect of rising bond yields should affect asset allocation, writing, "My major worry is the apportionment between stocks and bonds, thinking that the next 10 years or so bonds are in trouble."

Balancing the higher yields that go along with longer- and intermediate-duration bonds against the risk that rising rates could hit them hard is top-of-mind for SteveM. He wrote, "I do hold some longer duration municipal bond funds, and while I don't want to miss out on the goodies (i.e., the current returns), I wonder about my ability to get out at the right time.  Despite all the articles to the contrary, I worry that my intermediate term funds will not perform well in an environment with interest rates increasing."

Don1939's post takes note of the fact that many bond-fund managers got caught leaning the wrong way on the rate question last year. "If Bill Gross [with thousands of analysts] gets it wrong, what chance do we ordinary investors have?" he queried. "Slim or none, and Slim was just seen hitchhiking outta Dodge. A time is coming when fixed-income guys are going to have to make a really tough decision, where to put our fixed income money.” 

Even bond funds that navigated 2011's tricky bond market well, like DoubleLine's offerings, are giving some investors angst. Elgin1 wrote, "How can [manager Jeffrey] Gundlach keep up this pace and success?  DoubleLine Total Return (DLTNX) and DoubleLine Core Fixed Income (DLFNX) represent about 15% of my total portfolio. I did get out of  Fairholme (FAIRX) before the fall so maybe I can read the tea leaves on DoubleLine the same way."

Petrus1949's post illustrates the fact bonds can cause as much angst as their sexier stock siblings. "I did have one fund that caused me untold grief.  Nuveen High Yield Municipal Bond (NHMAX) was my first (and probably last) venture into the world of high yield munis. I'm surprised they don't need a gaming license to sell that fund. I sold it in 2010 after recouping some of the value. I sleep MUCH better now!"

For Bill1234, a foray into convertibles proved more trouble than it was worth. "I bought  Fidelity Convertible Securities (FCVSX) to get the best of both worlds and diversify into an asset class I did not own. I got that and a lot more volatility than I imagined possible. Lesson learned: the fund manager can make a relatively conservative asset class surprisingly risky and vice versa. My fault. I just did not pay enough attention to what I was buying."

Cash was vexing for other posters: Where to go to wring out any type of yield at all? Richendric wrote, "Right now my cash position in my tax deferred 401k is my problem child. In the past I could hold some cash during more volatile investment climates and at least know it was making a few percent. Now, I feel I have to deploy my cash into mutual funds ( the only investment vehicle available in the plan) to have a chance to make a return to keep up with inflation. How to balance risk/reward with the 'wall of worry'?"

Edmund_Dantes notes that the stable-value option in his 401(k) has also exhibited an incredible shrinking yield. "A significant portion of my company-plan assets are invested in a stable-value fund managed by Invesco. My concern with it is that the crediting rate (that is, interest paid) has dropped precipitously during the past 12 months or so. Until then, it paid 4%. Now it’s down to about 2.5%. With limited options within the company plan, I worry that my earnings have been cut almost in half over the past year, and I have few alternatives, and the choices I do have would expose my NAV to much greater volatility and risk."  

They've Fallen, But Can They Get Up?
While bonds and cash received plenty of attention from posters, so did stock funds that have hit a performance trough.

Problem children stock funds ran the gamut. Some posters mentioned sector-pecific holdings, including those focused on energy and precious metals, while others called out diversified equity funds as their portfolio's most troublesome.

Various Bridgeway funds received repeat mentions; though the firm's offerings have periodically generated very strong returns, recent performance weakness at some of the funds has tried some investors' patience.

Bitsotree wrote of Bridgeway, "How many times have I felt like kicking those little brats out of my house?! Every time they misbehave, I give them a little more money, hoping it will make them change their ways. Alas, they only take further advantage of me and I'm stuck with all of them."

Climbert is also keeping his Bridgeway fund on a short leash. "At this point,  Bridgeway Aggressive (BRAGX) is on probation. I've also held it for over 10 years, but if it doesn't rally soon it may be 2012's loss leader."

Fairholme Fund, the subject of an extended conversation among posters back in the fall, received several mentions as a problematic portfolio holding.

TexasRebel is worried about whether its basket of beleaguered holdings has what it takes to rebound. "Fairholme keeps me up at night thinking because of the Humpty Dumpty effect on its holdings of  Sears Holdings ,  Bank of America (BAC),  American International Group (AIG), and others. If these great companies cannot get it together over the past two years, and Fairholme says the numbers are there to see a turnaround in them, then what is changing in the world which makes good financial analysis weak and miss the mark?"

AKontrarian notes that Fairholme's big bet on financials is causing his own portfolio to veer toward the sector as well and is mulling the risk of that emphasis. "I follow a sector-wise strategy and try to keep my allocation in any given sector less than or equal to 10%. Fairholme going to a 75% bet on financials has me overweight on financials. With Buffett, Berkowitz and other gurus recommending financials, I can't bring myself to sell my way back to my preferred allocation."

What to do with a fund run by another big-name manager is on DeSouza's mind. " Legg Mason Value Trust (LMVTX) is the thorn in my shoe. I am the buy-and-hold type and have stuck with Miller. It is my only black eye in the portfolio. [I] don't want to move it to bonds, since it is down by half, but rather find something aggressive with a 10-year horizon."

Dtobisk finally pulled the plug on another Miller charge that was his own problem child in the past. " Legg Mason Opportunity (LMOPX), also managed by Bill Miller, was my number-one problem child until a couple of months ago, when I finally bailed out after holding it for over a decade. Not only was recent performance horrendous (except for a banner year in 2009), the expense ratio was hideous. Enough was enough. It made for a nice tax-loss item." 

One Person's Trash . . .
The thread featured a great discussion about what to do with struggling holdings. Should you use a zero-tolerance policy, as some posters espoused? Or are troubles in a holding reason to add?

Put Edmund_Dantes in the zero-tolerance camp, but with a twist. "I am a conservative investor. If a security worries me, I either reduce my position or avoid it entirely. With that said, when I do take a position which moves against me hard, it is usually in my taxable account (by design).  So I make a point to harvest tax losses promptly, replacing the position with a similar security, if my investment thesis is still intact."

Ditto for The 62 Dawg, who wrote, "We do not have problem children in our portfolio. We use a very military boot camp discipline in our portfolio--our way or the highway." 

Darwinian agreed that investors shouldn't put up with holdings that are keeping them up at night. "Please allow me to submit, again, J. P. Morgan's excellent advice: If your investments are keeping you awake at night, sell down to the sleeping point."

Yet Chang countered that sticking with underperformers--or even adding more--is part and parcel of successful value investing. "Most value investors would not agree. Securities that are 'worrying' may actually be good investments at their current trading price.  Really solid companies with great management, great product, wide moat, super R&D, solid balance sheet, no debt, etc. may be poor investments at their current trading price. Companies that give people reason to worry often sell off in panics, offering up good buying opportunities."

Rathgar neatly summarized the conundrum, but his post also indicates that there are rarely pat answers about what to do with struggling holdings. "My problem is not any specific holding but when to sell an underperforming money manager.  Has the manager lost his/her skill in managing money or is the fund in a slump because it is invested in low valuation sectors ( financials ) and poised for significant future outperformance?  Bill Miller had a terrible last 10 years and then he retires...on the other hand many good managers have slumps for two to five years and then come back.  Dodge and Cox Stock (DODGX), Fairholme, and  Hartford Capital Appreciation (ITHAX) are all underperforming yet have excellent long-term track records. When to sell? This is the question. Most investors buy and sell at the wrong time so the following the herd is clearly not the answer."

Speaking to investors' tendency to buy and sell at inopportune times, TOOOINTENSE quipped, "The only real problem child in my portfolios is me." 

Posts about Janus Overseas neatly illustrated differing opinions about whether a performance trough is a buying opportunity or a reason to sell. Some posters noted that they were rapidly losing patience in the fund, which lost one third of its value in 2011 thanks to its bets on emerging markets and troubled turnaround plays like  Bank of America (BAC).

Responding to my query about problem children in a portfolio, Stillers wrote,
"Janus Overseas.There. I said it. I feel better now. Awaiting the day I finally have it in me to completely give up on it. Hoping I have the strength to repress the fact that I owned it."

Other posters noted that they shared Stillers' skepticism on Janus Overseas, but Zweb2011 noted that he's researching the fund to determine whether to initiate a position in it. Markb has also been buying as the fund has dropped, writing, "I'm guessing the people mentioning Janus Overseas are newer investors in the fund; otherwise they'd be (somewhat) more used to the performance swings. I've been in the fund for a long time, and respect the manager's willingness to stick with his convictions. Over the years I've pulled a good portion of my chips off the table after a run-up, and lately I've been feeding money into the fund in small amounts now that it's in the low 30's. But overall one needs a long-term perspective with the zippy funds and be willing to slog through a period like last year."

'It Ain't Easy'
Fund investors weren't the only ones with angst about what lurks in their accounts. Marketwise pointed to a practice called rehypothecation as an unsung risk for brokerage-account holders, and Edmund_Dantes concurred. "The issue of re-hypothecation may be floating below the radar of some investors. It should not. As this layman understands it, 'rehypothecation' allows brokerage firms to make big bets with money borrowed from lenders, while pledging to the lender the margined assets of their clients. If the broker's bets go bad, causing a bankruptcy, the creditors can use the clients' pledged assets to make the creditors whole. My understanding is that is is what has happened to retail clients of MF Global--their accounts have been frozen, and may well end up satisfying the claims of the lenders to MF Global. MF Global made big bets and pledged its clients margined assets to make that bet. The authorization which allows them to do this is in the standard boilerplate margin agreement of most brokers.  If you don't accept the boilerplate language, you don't get a margin account (and so, cannot short stocks)."

Of his stock holdings, FidlStix wrote, "For me, it is 'problem children,' plural. One big lesson investing has taught me--and is still teaching me--is, it ain't easy, contrary to what some people say. When I got serious about investing in stocks several years ago, I wrote up a rationale with a few bullet points. One was, 'Only buy stocks that I can hold forever.' I've since learned that my 'forever' stocks may only hang around a few months in my portfolio. One is  Nokia (NOK). I recently dumped it when I saw the handwriting on this cellphone maker's wall."

For SteveM,  Avon Products  has consumed a disproportionate share of his angst, even though his stake is fairly small. "It was a wide-moat 5-star stock before it wasn't and it declined significantly last year. Fortunately it is a very small part of my portfolio, and my holdings of wide-moat global stocks, as a group, did well last year.” Idaho73 pointed out that Avon appears in the portfolios of some top stock-picking funds, including  Yacktman (YACKX)."

Bank of America has mucked up performance at funds like Fairholme, and it has also dogged individuals like mharris, who holds the stock directly. "I'm a retired buy-and-hold type with a dividend portfolio trying to decide what to do with my Bank of America. I don't see it coming back to my basis for years--however, in the near term it might have a sizeable increase as the economy rebounds."

Because stocks often consume more time for research and monitoring than funds, Dknesper, a retiree, is gradually scaling back on them. "Individual stocks tend to worry me more because regardless of the rating, anything can happen to a single company, and I really have no time to do the necessary monitoring. So, I'm slowly decreasing my individual stock positions."