Hold or Sell? How to Evaluate Fund Laggards

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. We all have a laggard holding or two in our portfolios. Joining me to discuss how to evaluate laggards is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, in the latest issue of Morningstar FundInvestor, you talked about how some funds have lagged recently and how to go through your portfolio and make a reasonable assessment about whether they are worth hanging on to because they will come through the performance slump or whether you should just cut them loose.

Let's start with a really basic question. Sometimes people look at their portfolio holdings and see funds that have way underperformed either the market or their peer groups and just decide to cut them loose. Is that a good approach?

Kinnel: No, it really isn't because you really need to understand the fundamentals, you need to understand why you own the fund. And you have to understand, too, that every fund is going to underperform, especially if it's a focused fund. So, therefore, you need patience and you need to really understand why the fund is underperforming. It's really dangerous to simply throw everyone overboard that underperforms for a year or two.

Benz: Say, I have a holding in my portfolio and it has way underperformed its category peers, maybe even over a five- or a 10-year period. What are the steps that I should take in doing my due diligence about whether this is something worth hanging on to?

Kinnel: I think you want to understand are there new problems that this slump highlights or is it more the case that maybe their strategy is out of favor. The markets tend to favor certain sectors, certain strategies and therefore leave other ones out of favor, yet those same strategies can come roaring back very quickly because the markets rotate, they correct. You want to see is the fund really continuing to do what it's supposed to do, are all the key people there. If all the key things are in place, you probably want to stick with it. Because again, the markets can rotate very quickly. And if you sell all of your losers, you may end up with next year's losers instead.

Benz: How about on the flip side? What are things that, if you are looking at a fund that has lagging performance and it also has X, Y, and Z problems, what are the things that you consider red flags?

Kinnel: It starts with people. Is the fund losing key managers or analysts. And then, I think, it's about process. Has the fund's process changed? And then, even things like fees. Sometimes underperforming funds will get a lot of redemptions and then all of a sudden, their fees are rising. And so, you do have a fundamental change. Maybe it's not necessarily their fault, but anyway, now you have a higher-cost fund and that reduces the odds of it coming back strongly.

Benz: This is a due diligence process that you and the team go through when deciding funds' ratings. Let's talk about a couple of recent examples of funds that have been under scrutiny because performance has been poor. Let's start with AMG Managers Montag & Caldwell Growth. This is a fund that the team recently downgraded. Let's talk about the factors that affected that downgrade. Its performance has been weak, but what else was going on there?

Kinnel: That's right. The performance has been weak and some of that we can attribute to a high-quality bias which for the most part in the last few years hasn't worked that well. And we could cut it some slack for that, but the fund has had some personnel changes. The lead manager is set to change at year end. So, that's a pretty big deal. And also, we saw fees are rising. As I mentioned, because assets are flowing out of the fund, fees are rising at a time other funds are getting cheaper and cheaper. So, the bar is getting raised, as it were, by lower fees. And so, you do have two fundamental deteriorations at the fund that give us a concern and have led us to lower the rating to Neutral.

Benz: This is a fund that had been a medalist but now it's down to Neutral because of the factors that you mentioned?

Kinnel: Exactly.

Benz: Let's talk about another growth-oriented fund, ClearBridge Aggressive Growth. This is one that also has had weak performance, but the team has maintained its Silver rating. Let's talk about the things that keep us liking the fund despite the weak performance.

Kinnel: This fund is a little bit quirky. And so, I think, to own a quirky fund you really have to accept those quirks from the beginning. And in this case, Richie Freeman is a very low turnover investor. Typically, turnover runs like 1% or 2%. It's even lower than an index fund …

Benz: Which is not something you often see with growth-leaning funds.

Kinnel: That's right. Very patient manager. If you look in the portfolio, there are names that go back 20 years or more. One of the issues today is that the fund doesn't have some of the FAANGs and some of the other really hot stocks because, again, it changed the portfolio very slowly. And so, some of the time those names are going to be out of favor with the market. And that's what's happening today.

Benz: You did a deeper dive into a number of other funds that have recently had disappointing performance, so people who are interested in reading about those, can go ahead and see the latest issue of FundInvestor.

Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.