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Breaking Up Is Hard to Do

Like many of his clients these days, Don Dion doesn't have much patience with funds that have underperformed their benchmarks. Dion, president of Dion Money Management, a registered investment advisor in Williamstown, Mass., affiliated with Fidelity Investments institutional brokerage group, says he starts thinking about selling after a fund has lagged badly for six months. A lot of funds have collapsed,

Like many of his clients these days, Don Dion doesn't have much patience with funds that have underperformed their benchmarks. Dion, president of Dion Money Management, a registered investment advisor in Williamstown, Mass., affiliated with Fidelity Investments institutional brokerage group, says he starts thinking about selling after a fund has lagged badly for six months. “A lot of funds have collapsed, and many losers will never come back,” he says.

Some investment research supports Dion's view. All too often funds that hit the cellar stay there for prolonged periods. But there has never been a foolproof way for determining when to sell; plenty of successful advisors look at a variety of factors and wait years before pulling the plug. In today's difficult markets, making a decision about whether to sell can be particularly hard. Investors must ask, “Has a fund really turned sour, or is it just suffering from extreme market conditions?”

Before making a move, many advisors look for clear sell signals. Signs of trouble could include an unexpected shift in investment style or the departure of a fund manager. Below we examine some traditional warning signs — and consider how they should be used in the current market.

Performance blahs

The first thing many advisors consider is past performance — even if it provides uncertain guidance. A recent study by the Charles Schwab Center for Investment Research confirmed that it pays to weed out losing funds sooner rather than later. For its study, Schwab assembled a theoretical portfolio of funds with top risk-adjusted returns. Then the researchers considered the results of various strategies, including simply holding the funds for a decade or selling ones that sagged. The best results came from eliminating funds after they dropped into the bottom quartile for one year. Waiting for two or three years to replace the losers resulted in worse returns. “If a fund lands in the bottom quartile of its category for a year, there could be some serious problems that won't go away,” says Bryan Olson, a Schwab vice president.

To be sure, Olson cautions that investors must look beyond the raw returns to determine why a fund might be lagging. The first question to ask is whether the benchmark is providing a reliable measure. Funds might be underperforming simply because their style could be temporarily out of favor, a common problem in the erratic markets of recent years. In the late 1990s, growth stocks soared, and many value-oriented managers lagged their benchmarks. Then the tide turned in 2000, and value ruled. Now, many funds with top three-year records are ones that do best in bear markets. It is surely worth owning a resilient choice or two, but bear markets have traditionally been relatively rare. Long-term investors must consider whether they want to load portfolios with funds that only excel during unusually steep downturns.

To appreciate the problem, consider Gabelli Westwood, a large-cap value fund that looks for stocks with improving earnings. With its emphasis on growth, the fund ranked as a star of its category during the bull market. Then during 2001, Gabelli dropped to the bottom quartile of the large value group, and last year the fund again delivered a mediocre showing. Is it time to sell? No, says Robert McCarthy, president of Kanon Bloch Carre, an asset management consultant in Boston. “When growth stocks start doing better, this fund will be a leader again,” he says.

Slipping styles

For many advisors, the worst sin a fund can commit is style drift. This occurs when managers — perhaps trying to boost short-term results to save their jobs — buy stocks that fall outside their normal investing styles. In the late 1990s, many value funds began slipping growth issues into portfolios. Lately growth partisans have begun adding value names. In some instances, fund companies have shifted completely. Ivy International and Dreyfus Founders Balanced both dumped value-oriented managers and replaced them with growth-leaning specialists — just as growth was peaking. In such extreme cases, there is an obvious reason to dump funds that no longer fill the roles they once played in portfolios.

Victims and Victors
Time to sell? These funds struggled after a change of style.
Fund Ticker Category One-Year Return Three-Year Return Five-Year Return Max. Front Load
Dreyfus Founders Balanced A FRIDX Hybrid -15.1% -13.4% -7.1% 5.75%
Ivy Int'l A IVINX Foreign -20.9 -19.4 -9.6 5.75%
Keepers: While shifting style boxes, these funds stayed on target.
Brandywine BRWIX Mid Growth -20.8% -17% -0.8% None
Davis New York VentureA NYVTX Large Blend -16.8 -8.2 -0.2 4.75
Legg Mason Value LMVTX Large Blend -13.1 -10.2 1.7 None
Source: Morningstar. Returns through 2/28/03.

For advisors, the more difficult calls occur when a fund makes a relatively small shift, perhaps moving from Morningstar's small value box into small blend. Russel Kinnel, Morningstar director of fund analysis, cautions that limited shifts might not necessarily indicate that a fund is truly changing its style. “Many funds fall right near the borderline,” he says. “In those cases, the manager may be following his normal strategy, and the portfolio may move from the value box to blend.”

Top funds that sometimes straddle boxes include Davis New York Venture, Legg Mason Value and Brandywine. A veteran bargain hunter, Legg Mason's William Miller fell in the value box in 1999 as growth stocks became expensive. Then as value climbed, he began going for stocks with more growth characteristics, and his fund moved into the blend box.

To find out whether a fund is drifting too far, investors must do more than review style boxes, says Kinnel. It is important to examine individual holdings and look at such factors as the percentage of assets in each industry.

The skipper jumps ship

In recent years, hundreds of funds have changed managers annually. In some instances, the skippers jumped to higher paying jobs at hedge funds or other money manager firms. Often the managers were pushed overboard as fund companies sought someone who could offer a smoother ride. When such a change occurs at a solid fund, investors should typically do nothing, says John Sterba, chairman of Investment Management Advisors in New York. “If the new manager is following the same strategy, you might as well stick around and see what happens,” say Sterba.

Sterba has long owned Mutual Shares, a deep-value choice. When the manager quit in the late 1990s, Sterba waited patiently to see what approach the new team would take. They struggled in the growth market, but did not waver from their strategy. So Sterba held on and was rewarded when deep-value came back to favor and Mutual Shares soared. Sterba's thinking was confirmed by a recent Morningstar study that looked at the impact of manager changes on performance. The research found that manager changes on average did little to revive the performance of bad funds. Good funds tended to perform well after a manager change. Apparently, some companies are not very good at running funds. Others excel at picking managers and producing competitive results. So once you have found a good fund, it pays to wait patiently through good times and bad.

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