Why You Need a 'Watchlist' for Your Portfolio

In an ideal world, you've made considered investment decisions; assembled your portfolio methodically, brick by brick; and you're the picture of serenity, sticking with your choices through thick and thin, come what may.

But reality is messier. In the real world, you've not selected so much as amassed: Your investments sprawl across multiple retirement and taxable accounts, reflecting where you were at various points in your investing and professional life, but without forming a cohesive whole. And you're prone to worry, as you don't have a good system for keeping track of issues and events that might affect your investments.

You need something. You just don't know what.

The Watchlist Enter the watchlist. A watchlist is a common tool used by institutional money managers and consultants to keep tabs on their holdings.

My own team, for instance, reviews our list of approved funds on at least a quarterly basis using a quantitative alerts system that's useful in identifying potential watchlist candidates. Once we've flagged a potential candidate, we dig deeper, conducting fundamental research to determine whether a fund actually should be placed on watch.

As an individual investor, you may not have access to a tool like this. But you can set up your own watchlist in a few easy steps:

1. Identify relevant factors. What are the most important potential concerns that you want to include on your review checklist?
2. Determine criteria and thresholds. These are standards for what constitutes a change serious enough to warrant placing a fund on the watchlist.
3. Set a schedule. Decide how often you want to engage in your review process.
4. Conduct the review. Determine whether any triggers and flag funds need further investigation.
5. Record notes for follow-up. As part of my own team's process, we write up formal memos any time a fund goes on or off watch. As an individual investor, you needn't necessarily go to such lengths, but it still can be useful to keep a record of why you placed a fund on watch and what you would be looking for in subsequent reviews.

Building Out Your Watchlist Criteria To get you started, here are some key criteria my team at Morningstar uses in building and maintaining watchlists for clients. Criteria like these can help you decide whether to place a fund on watch.

1. Manager change. A manager change is one of the more common triggers we encounter. Some changes are inconsequential: For instance, where a less-tenured member of a team departs. In those circumstances we would almost never place a fund on watch. But other times manager changes matter a lot. For example, even if a comanager is being groomed to succeed a more-senior colleague, that creates uncertainty, which can warrant putting the fund on watch. Most concerning is a situation where a seasoned manager departs unexpectedly, and the firm is ill-prepared to appoint a replacement; such cases are likely to result in an on-watch status.
2. Portfolio change. Some investors prefer funds that hew to a certain style of investing. Given this, we flag funds that have shifted out of their historical spot in the Morningstar Style Box. Does style drift automatically put a fund on watch? No, provided the drift isn't extreme--think of a fund hopscotching between large and small or value and growth from one month or quarter to the next--and there are reasonable explanations for it. For instance, a fund may live along the border between one region of the style box and another, or perhaps a manager hasn't been style-pure to begin with, as with more opportunistic types who swan around the style box looking for bargains. However, investors should give closer scrutiny if a portfolio shift suggests a fund has departed significantly from its stated investment philosophy. If that's the case, you should probably put the fund on watch.
3. Unexpected performance. The first step is to determine what performance metrics you want to incorporate: performance relative to category or benchmark, volatility, down-market performance, risk-adjusted returns? We take a multifaceted approach, but we do have quantitative screens that flag poor performance relative to peers and high levels of Morningstar Risk. Those flags are generally just a starting point, however, toward a deeper dive on the fund's performance characteristics. Probably the key point when evaluating an underperforming fund is to have a baseline expectation for that fund's performance characteristics? That way, you won't get thrown into a panic every time your manager goes through a dry spell (which virtually every active manager is prone to do). Short-term periods of underperformance typically don't warrant watchlist status; more concerning is underperformance that is sustained and/or at odds with expectations for the fund.
4. Fee Increases. Given that expenses are one of the most predictive factors for future performance, it's a good idea to keep an eye on your fund's fees. Although it's not very common for fund companies to raise their levies on investors, especially given the general trend toward lower fees in the industry, it does happen sometimes. Usually if fees rise, it's because a fee waiver previously in place has been removed or because a fund has shed assets and lost out on economies of scale from spreading fixed costs across a smaller asset base. A fund's relative attractiveness on fees may also shift if its peers on average have been reducing fees while the fund has been standing still. You can use Morningstar Fee Level rankings (which compare a fund's expenses against category peers in similarly distributed share classes and are available in a fund's Quicktake report on Morningstar.com) as a guideline. If a fund that was previously ranked Below Average moves to Above Average, for example, you might want to place it on watch, with an eye toward determining whether the fee hike is something likely to reverse over time or stick.

Next Steps The above list is not all-inclusive but covers the bulk of issues you're likely to encounter. Remember that a fund on watch isn't necessarily a sell--it's merely a step toward heightened review. Down the road, you'll need to make decisions about whether to take the fund off of watch, or sell it and find a replacement. Those are topics I hope to tackle in future columns.