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When to Sell an Actively Managed Mutual Fund

A friend recently sent me an email asking for my advice regarding a one of his mutual fund holdings.

The fund underperformed the market pretty seriously over the last year. As a result, it now has 3-year and 5-year performance records that are below those of either an S&P 500 index fund or a Wilshire 5000 index fund–despite the fact that the fund was a big outperformer in prior years.

His question was how to know whether the fund manager had “lost his touch.”

My answer, of course, was that there’s no way to know. And in fact, it’s impossible to say for sure whether the fund manager ever had a “touch” to begin with.

His question highlights what I see as one of the biggest issues with holding actively managed funds:

  • If the fund has outperformed the market over the period that you’ve owned it, how do you know whether the fund manager has genuine skill or just good luck?
  • If the fund has underperformed, is it because the fund manager “lost his touch?”* Or is he still a skillful manager–one who has simply had a bad year? Or, was the fund manager never skillful to begin with?

In either case, you’re stuck asking yourself, “should I continue holding this fund?”

Index Funds & Peace of Mind

By way of comparison, with an index fund, you never have to rely on the existence of a brilliant fund manager. All you’re betting on is the likelihood that the businesses of the world, over time, earn a net profit.

(Side note: That’s just one of the reasons why I sleep better at night knowing that I’m invested in index funds.)

What about you?

For those of you who invest in actively-managed funds, how do you decide when to throw in the towel and find a new fund?

*In terms of the possibility of a fund manager “losing his touch,” I doubt that any truly skilled professional would spontaneously lose his skill. However, if his above-average performance was the result of exploiting a particular market inefficiency, it’s possible that that inefficiency could eventually be eliminated, causing the fund’s above-average performance to end.

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Comments

  1. Typically people would rather stick with what they have and under preform the market than make a change. If they switch they fear they will be responsible for missing out on future gains if the fund turns around.
    One factor for consideration is also the load factor. How much did you pay to get into the fund?
    I would not make a change after a year of underperformance. Likely you have a more aggressive fund so if/when the market turns around you have ridden the market down with an aggressive fund and you probably do not want to go into the bull with a conservative fund.
    Under normal circumstances if something trailed the market over a 3 year period I would dump it. 2008 requires a reconsideration of that general rule.

  2. I don’t invest in actively managed funds, but I used to. I decided to throw in the towel, not because of any thing the fund managed did, but when I remembered 10-2=8 and not 10-2>10 like the actively managed funds would want us to believe.

    As far as loads that were paid, those are sunk costs. That money is gone forever, whether you continue to hold an actively managed fund you no longer want or make a change to a no-load, index fund. It has no bering on the outcome and is, at best, a purely psychological consideration. And back-end loads will usually more-than-pay for them selves out of expense savings going forward.

  3. I’m not a fan of managed funds. But the one circumstance in which I would buy a managed fund is if I felt strongly about one particular segment of the market or one particular strategy and there was a fund that permitted me to invest in that segment or using that strategy without having to do the research myself (the reason why I am not a fan is that I think it is better to do the research yourself or else just stick with indexes).

    So what I would look for re getting out is signs that the fund was not doing what it was supposed to do, that it was not investing solely in the segment or according to the strategy that it was designed to pursue. Lots of funds do not do what they purport to do in the marketing materials (another reason why I am not a fan).

    Rob

  4. Has the fund manager changed in the last 12-18 months? It could be that it has and the new fund manager is a bozo.

  5. JerryB: In this particular instance, no. The same fund manager has been there for more than 10 years.

  6. When fund managers tell us that past performance is not indicative of future performance, they mean it.

    Studies have shown that the best-performing funds tend NOT to stay at the top of of the list for long.

    Bottom line – except for being lazy, the only reason to hold a fund is to avoid expenses involved with reinvesting the cash. And that’s a poor reason.

  7. Since the manager has not changed I would tell him to check and see if the fund’s mandate has changed or if it has been merged. If such changes have taken place, then I would recommend selling. One bad year is no reason to sell a fund. Chances are that if it took such a hit it may be a growth or value focused fund and that 2009 could be a very profitable year. For curiosity’s sake, are you willing to share which fund your friend is invested in?

  8. I’ve been wrestling with a somewhat similar issue lately. Several years ago when I opened my first Roth IRA, I didn’t really know what I was doing. I put half of the money in a target date fund and the other half in a managed fund. Were I starting again today, I’d put it all either in the target date fund or in a few index funds. I’m debating now on whether it’s best to sell the managed fund (which is down quite a bit from when I first invested), or to leave it alone and just contribute all future dollars to the target date fund.

  9. Kent: I was asked not to (otherwise I would have included it in the post originally). I’ll describe it this way: It’s a fund you likely haven’t heard of, from a fund company you have heard of.

    Beth: That’s a tricky situation. My only advice would be to remember that–as long as there’s no charge to get out of the fund–sunk costs (including poor prior performance) should be ignored.

    Try to think of it in these terms: If at this moment, all of the money were in cash rather than funds, how would you invest it?

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