Do you own a mutual fund that was a loser in 2011? If so, you’re not the only one. Morningstar reported that active managers struggled to beat their benchmarks in the fourth quarter. Just two of the nine Morningstar style groups had more than 50% of managers beat their benchmarks.

So, what should you do?

First of all, don’t panic! Recognize that short term under-performance is inevitable. In my previous post I showed that almost all of the top long-term managers suffered a period of underperformance lasting 3 years! So, one quarter or one year of under-performance should not be the sole reason for selling a fund. However, it should trigger a review. There may be other factors that would make a case for selling.

We monitor performance of our mutual fund positions on a monthly basis. Each month we compare them to a benchmark. We pay special attention to the trailing 3-month, 1-year, 3-year, 5-year, and 10-year returns versus the benchmark. A mutual fund is placed on watch if any of these returns fall below their benchmark. A watch signal will trigger a thorough review of that fund to discover the reasons for under-performance.

So what items should you review when you notice your fund is underperforming? 

Start asking questions. Lots of them. Don’t make an emotional decision to sell on peformance alone. Get the details before making your decision to hold or sell the fund.

Here are five questions to ask yourself:

  1. Have their been any changes to the investment team? Take a look at the manager(s) on the fund. Has a manager left the firm, retired, or been fired? Has their been any analyst turnover on the team?
  2. Why did the fund underperform? The best way to find out is to call the fund company and ask. As an investment management firm we have good relationships with the funds our clients are invested in. If we have concerns about performance we can call and request an attribution analysis. A good attribution analysis will break down the performance by asset class, country, sector, and/or security and show you exactly what investment positions added to performance and which detracted from performance. Many companies will publish an attribution analysis for advisors on a regular schedule.
  3. What are the funds cash levels? Many times a fund will under-perform on the upside if they hold a significant amount of cash. Find out why they hold so much cash. Is it because they lack buying opportunities when following their investment discipline? Is it because new money (inflows) is coming in faster than they can put it to work? On the other hand, a fund manager might be dealing with an excessive amount of redemptions (outflows). If that’s the case, they may be forced to liquidate positions at an inopportune time.
  4. Has the manager’s investment discipline changed? Have you noticed the fund manager going outside of their mandate or area of competence? If your large cap value manager suddenly starts trading commodity futures that would be cause for concern. You want your manager to stick to their investment discipline through the tough times. You don’t want your manager chasing performance by venturing into unfamiliar areas.
  5. Has the manager’s investment process changed? How does your manager execute his or her investment discipline? If the past track record was built on bottom-up fundamental stock picking has suddenly been replaced with a quantitative macro approach that is a sign that the manager isn’t sticking to their knitting.

So when should you fire a mutual fund? Here are some reasons that may justify selling your under-performing fund:

  • There has been a manager change and the new manager does not have experience running the same or a similar strategy.
  • There has been a period of prolonged under-peformance. Especially if there are plenty of better options with similar investment strategies.
  • There has been a change to the investment strategy where either the manager isn’t sticking with the discipline that used to work or no longer follows the same investment process.

As you can see, knowing when to sell a mutual fund isn’t a simple decision. First, it assumes you did the work when you bought the fund. It assumes you already know the fund manager and you have a good understanding of the manager’s investment strategy. It assumes that long-term historical performance was good when you bought the fund. When making a decision to sell you are looking for things that may have changed from the circumstances that were in place to build the prior track record.