Everyone knows that in the mutual fund world, there are good funds and bad funds. Typically, funds that perform well attract new money, and funds that perform poorly usually experience outflows as investors jump ship. But you really have to wonder about those funds that languish year after year, posting poor performances, yet somehow still manage to keep a significant asset base. Why don't fundholders sell these dogs and find a better use for their investment dollars? Fortunately, some new research may shed some light on this phenomenon.
Stubborn loyalties
According to a recent study released by finance professors from the University of California at Berkeley and the University of Exeter in Britain, a poor fund has a much greater chance of remaining that way than a top-ranked fund has of remaining at the top. The study identified a potential reason for this: Investors are oftentimes unduly loyal to their chosen funds, refusing to sell no matter how bad their performance gets. Because this group of loyal investors won't cash in shares, the fund doesn't become small enough to begin to become competitive again. It's not exactly clear why this group of investors refuses to sell the losing funds, but it's thought that they simply may not want to constantly monitor and check up on their funds. They want a "set it and forget it" fund allocation, without having to do regular checkups on their funds.
One of the authors of the study recommends that to avoid getting stuck with underperforming funds, investors should take a look at their portfolio at least once a quarter and determine how each of their funds ranks over the past 12 months. He then advises selling any fund that is in the bottom 20% of the rankings and moving that money into a fund in the top 20% of rankings. This way, investors can be relatively assured that they won't stay in underperforming funds.
A Foolish take
I agree that many investors are too loyal to their funds, continuing to hold even when things have been heading downhill for a long time. There is a big psychological reason for this: Most fundholders hate to sell at a loss. "Sure, my fund is down 20%, but if I can only hold on until I break even, then I'll sell!" People hate to admit they made mistakes, and tend to hold on in hopes of eventually justifying having bought the fund in the first place. Don't fall into this trap. If your fund no longer meets the initial criteria for which it was bought, cut your losses and move on.
I also think that regular fund monitoring needs to be a part of every Fool's investment strategy. It's not enough to find a handful of good funds and then sit back and put your portfolio on autopilot. Yeah, you may still have your exposure to highfliers like Cisco (NASDAQ:CSCO), Red Hat (NYSE:RHT), and Comcast (NASDAQ:CMCSA), but you need to ensure that your fund managers are still doing what they say they're doing.
Less is more
But I part ways with the advice given by the author of the study regarding the recommendation to shuffle your funds each quarter, based on where the funds rank over the past one year. I think these kinds of frequent adjustments to your portfolio are a recipe for disaster. If you try to move into the best-performing funds every three months, you're only chasing performance -- never a good investment strategy. By all means, examine your funds thoroughly each quarter, but don't sell in and out of them frequently, based on just one year's performance. Even good funds will have a bad year, and if you get rid of them based on that bad year, you may very well miss any recovery the fund experiences. Remember, the idea is to buy low and sell high, and by pursuing such a frequent trading program, you are in effect doing the exact opposite -- selling those funds that are down, and buying those that are up.
Unfortunately, I can't pinpoint exactly when you should pull the trigger on a fund for bad performance -- it will vary from fund to fund, depending on the reasoning behind the underperformance (market environment, management decisions). But I do think funds need to be given wider latitude than one year of bad performance. Consider the performance in the context of the market environment, and use that analysis in your decision.
I would keep an eye on any fund that underperforms during a one-year period, but I wouldn't necessarily sell. Two years? Maybe. Three years? Probably. The point is that you want to get out of bad funds in a timely manner, but you don't want to get rid of good funds that just have a stretch of bad performance.
It's a fine line, and the only way you'll be able to walk that line is by paying close attention to what your funds are doing and to what is going on in the market in comparison. And just by doing that, you'll be ahead of the majority of fund investors right out of the gate, putting you in a much better position for investment success.
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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies mentioned here. The Fool has a disclosure policy.
