Tired of all the red ink in your monthly statements? The answer may be to get rid of some of your bad-performing mutual funds.

With the exception of energy and commodities funds, investors haven't had anywhere to hide lately. According to Morningstar, the average large-cap stock fund has fallen about 6% so far this year, while small- and mid-cap funds are also down. Even international funds, which have given investors a safe haven in recent years, are down overall, with both developed and emerging-markets funds down between 7% and 8% year to date. Fund owners have responded by abandoning stocks, with net outflows from equity funds so far this year totaling $31.5 billion.

Before you decide to give up on all your losing funds, however, put your emotions aside and take a closer look. Just because you lose money over the short term doesn't mean that you've got a lousy fund.

It's all relative
As an example, consider the two funds in the table below. Which fund is worse?


YTD Return

1-Year Return

3-Year Annualized Return

Saratoga Energy & Basic Materials I (SEPIX)




Vanguard 500 Index Fund (VFINX)




Source: Morningstar.

From a total return perspective, the Saratoga fund has clearly performed a lot better than the Vanguard fund. With concentrations in energy stocks like Tidewater (NYSE:TDW) and Halliburton (NYSE:HAL), along with materials companies such as U.S. Steel (NYSE:X) and Weyerhaeuser (NYSE:WY), the Saratoga fund is heavily invested in exactly the sort of stocks that have done best lately.

Looking at absolute performance, however, doesn't give you an accurate picture of how your fund managers are doing. The average energy and natural resources fund did even better than Saratoga -- up more than 15% year to date, nearly 32% over the past year, and almost 28% annually over the past three years. Meanwhile, the Vanguard index fund did exactly what you would have expected: It gave you the S&P 500's return, less about 0.1% to cover its expenses.

If you own a number of sector funds, relative performance becomes even more important. Individual sectors rise and fall much more than the market as a whole, so you'll see losses more often.

For instance, looking at Dreyfus Premier Health Care I (DHCRX), its 2% loss year to date and slight loss over the past year -- thanks in part to tough years for Merck (NYSE:MRK), Wyeth (NYSE:WYE), and Hologic (NASDAQ:HOLX) -- might tempt you to sell. But actually, typical specialty health-care funds have done much worse, losing an average of 8% so far this year and 7% over the past 12 months. The Dreyfus fund looks a lot better when you consider it in this light.

The right time to sell
The lesson here is that if you have a well-diversified set of funds, you have to expect that some of them will lose money occasionally. If you sell your losers, you'll end up with a concentrated portfolio in hot sectors -- and when they come back to earth, you won't have any other investments to help cushion the blow to your net worth.

Instead, here are things to look for to tell if one of your funds doesn't deserve to stay in your portfolio:

  • Category underperformance. As we said above, how a fund does compared with its peers is extremely important. While a fund might slip from above-average performance for a little while, several years of subpar returns may be a signal that the fund's strategy is out of touch with the current market.
  • High expenses. When stocks are rising, it's easy to ignore costs. But in good times and bad, high expense ratios and fund fees take a constant toll on your portfolio's value.
  • Manager turnover. Many funds are graced with strong managers with a long track record of superior performance. When successful managers leave, however, that superior performance might leave with them. At the very least, you should track future performance closely to make sure the new managers are keeping pace.

The best way to invest for the long run is to put together a strong asset allocation strategy that includes the best funds you can find from different categories. Because each fund serves a purpose in your overall portfolio, it's smart to evaluate your funds on whether they're serving that purpose. Often, the answer will be yes -- even if you've lost money recently. Even funds that suffer losses from time to time can still make you rich in time.

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