The SMI Upgrading strategy is based on the observation that stock market leadership rotates among companies of different sizes and among different investment approaches. Because most mutual funds don't alter their management style based on what the market is doing at any given time, the performance of individual funds tends to ebb and flow as this market rotation takes place. Upgrading uses mechanical guidelines to identify funds currently "in sync" with the market, as evidenced by their performance leadership. It also signals when funds we already own are losing ground relative to their peers and need to be sold.
This regular process of identifying laggards and replacing them with funds showing greater current momentum is the heart of the Upgrading strategy. But over the years, we've found that some readers fail to act promptly on our recommendations, especially when advised to sell funds they own. There are many reasons why this happens. Perhaps they're busy when the current issue of SMI arrives, or are trying to hold a fund long enough to avoid a transaction fee at their broker, or are waiting to reach the 12-month holding period required to qualify for long-term capital gains tax treatment, or they simply like a particular fund and believe it will bounce back.
Because Upgrading has compiled a strong historical track record, we encourage readers to make their trades promptly and ignore these other factors as much as possible. After all, that strong track record is calculated based on the recommended transactions being implemented promptly. However, we know this doesn't always happen, so we've tried to quantify the cost of holding a recommended fund after a "sell" recommendation has been issued. Sometimes these costs are obvious — the old fund goes down while the new fund goes up. Sometimes they're relative costs — the old fund may continue to go up, but not as quickly as the new fund. Both types can make a significant difference to your long-term performance.
Big changes in the market's overall trend tend to produce the most dramatic examples of this effect. For example, as the market started to rally in 2009, we sold First Eagle Overseas in July. Over the next three months, it gained 13.6%. That seems pretty good, until you consider that the fund it was replaced with, Oakmark International Small Cap, gained 26.9% over that same period. A few months later, we replaced Hussman Strategic Growth with Oakmark Select. Over the following three months, Hussman lost -0.9%, while Oakmark Select gained 9.1%. In both cases, delaying by just a few months resulted in a double-digit performance swing, illustrating the importance of making recommended trades promptly.
True, we do not see such dramatic differences every time. But as the table above shows, it's not just on rare occasions that the failure to promptly upgrade carries a performance cost. We examined every Upgrading recommendation made over the past five years (2006-2010), and the results are summarized in the table. It's worth noting there's not a single risk category or time period where delaying resulted in better average returns. The closest was in the large/value category, where during the first month the average new recommendation only broke even vs. the average fund being replaced. In every other instance, promptness paid off.
Long-time readers may remember seeing this type of data before, as we've kept tabs on the cost of procrastination for more than a decade. While the data ebbs and flows a little, the 1- and 3-month costs have been consistent. As a rule of thumb, it's fair to expect the cost of delaying to be a little more than one-half percent per month.
Some readers will occasionally find themselves in a situation when it's worth taking that risk. For example, if you're looking at selling a fund one month before its 2% short-term redemption fee disappears, it may be worth taking your chances and holding another month.
It's important to note that the average cost of waiting varies quite a bit between the categories. The average procrastination cost in Categories 4 and 5 was noticeably greater than the overall average, reflecting the higher volatility (both up and down) of those categories. By contrast, the large-company value funds in Category 1 showed little difference the first month.
As you can see, most readers will be better off making Upgrading fund changes as soon as new recommendations arrive. But a closer examination by category is prudent if you're debating whether to delay for tax purposes or to avoid a transaction fee. In those cases, if it's not a foreign or small company growth fund and you're within a month or two of your goal, it may be worth waiting. Whatever your situation, determine exactly how much longer you would need to hold the fund to achieve your objective. With that time frame in mind, you can crunch the numbers using these averages and put the odds in your favor.