That well-known investment philosopher Kenny Rogers said volumes when he sang the chorus: You got to know when to hold ’em, know when to fold ’em, know when to walk away, know when to run. And also: The secret to survivin’ is knowin’ what to throw away and knowin’ what to keep.
Most investors will concede that reaching a decision on when to sell a fund is almost as daunting as deciding what to buy in the first place. The process is made more difficult by three personal fears that can paralyze you.
- Fear of Regret
You “just know” that as soon as you unload the dead wood, it will magically spring back to life. After holding it at a loss through thick and thin, you’ll watch glumly from the sidelines as your former holdings soar! This is an irrational kind of paranoia, but because it does happen occasionally, it looms large in our thinking.
- Fear of Failure
There’s also the fear that, having sold the laggards, you’ll make a mistake when selecting replacements. How do you know you’ll be better off? You don’t. What if the replacements do poorly? You might end up worse off than if you’d taken no action at all.
- Fear of Embarrassment
Will your husband or wife be critical if your changes don’t work out as planned? What about your friends at work, the ones you like to share 401(k) investing ideas with? Will they talk about your “bad” decision behind your back? Or your advisor, who may be suggesting that you “give it a little longer” — will he think less of you?
Let’s look at four primary reasons for selling, and see how you can approach the decision-making process in an objective way that neutralizes your fears and frees you to take timely and appropriate action.
- Sell when you want to change your asset allocation.
Your “asset allocation” (also called “portfolio mix”) refers to the way you divide your money among several different classes of investments. The term is most commonly used in reference to the percentage of your portfolio that you invest in stocks as distinguished from interest-earning investments such as money-market funds and bonds. Asset allocation can also refer to the way you subdivide your money further among various stock and bond categories. Your asset allocation will vary depending on which strategy (or mix of strategies) you choose. For example, if you choose SMI’s Stock Upgrading strategy, you’ll follow one set of allocations for that portion of your portfolio. In contrast, a portfolio following Dynamic Asset Allocation will use different allocations and will see those allocations change from time to time, as the strategy’s name implies.
Ultimately, you will be the one to decide on a portfolio mix that seems best given your age, goals, and risk tolerance. Commonly, investors move in the direction of lower risk (i.e., a smaller percentage allocated to stocks) as they advance in age or achieve their financial goals. When this happens, you will need to sell some stock holdings and invest the proceeds in interest-earning securities.
- Sell when your fund no longer fills its assigned role.
When you purchase a fund, you expect it to invest in a certain class of asset (growth companies, for example). Occasionally, due to market conditions or an influx of new money to invest, a fund manager will slowly begin to compromise his original strategy to accommodate the situation. If this continues long enough, you’ll find that the fund no longer fills the role for which you purchased it in the first place. One glaring example of this was observed during the tech boom of the late 1990s, when many value managers added high-growth dot.com companies to their portfolios to spice up their performance. This evolution in strategy is called “style drift.”
It could also be that the tools used by fund analysts such as Morningstar are refined, and a fund changes categories because of new guidelines rather than actual style drift on the part of the manager. In either event, your holdings may no longer reflect the portfolio mix you were aiming for and a fund has to be sold to remedy the problem. If you follow SMI’s strategies, you don’t need to concern yourself with this issue, as we handle it for you. But if you’re choosing funds on your own, it’s something to keep an eye on.
- Sell when you’ve got a compelling tax reason.
Sometimes it’s advisable to sell a fund solely for the tax benefits. Usually this means selling a fund in a taxable account in which you have a loss. The loss can be used to offset capital gains dollar-for-dollar, or it can be used to shelter up to $3,000 per year in ordinary income. On the other hand, if you’re experiencing a low-income year, you may want to sell a fund in which you have a profit in order to move the tax liability into the current year when your effective tax rate is lower than usual. On rare occasions, you might wish to sell a fund to avoid an unusually large capital-gains distribution scheduled for year-end.
- Sell when your fund is performing poorly.
As our economy continually moves through its growth-recession-growth cycle, earnings prospects of companies are affected in different ways. Some firms are relatively “recession-proof,” while others suffer considerable losses in sales and earnings. That’s one reason performance leaders (and the funds that invest in them) change from year to year. As your various portfolio holdings begin to falter, as they inevitably will, you need to sell the laggards and replace them with the new leaders. This is what SMI’s Upgrading strategy is designed to do for you.
This seems like common sense. So why doesn’t everyone routinely clean out poor performers? In large part, I believe it’s due to the fears I mentioned at the outset. To postpone making a difficult decision, many people are quite adept at justifying their inaction. Perhaps the most common rationalization is: “I’ll sell as soon as my fund gets back up to what I paid for it.” But if that doesn’t happen, there is no backup plan. Instead, many investors simply try to remain optimistic and hope for the best. Have you ever said to yourself:
- “This fund did great in 2013; it’ll do great again soon.”
- “The fund manager was upbeat in the latest report.”
- “Morningstar still gives it four stars!”
- “I’m too busy to research new funds, so I’d better just keep what I have.”
- “I’ve made good money with this fund; I’m still ahead even after the recent weakness.”
Upgrading automatically repositions you for changing markets
It’s important to have a selling strategy to nudge you out the door when a fund you own underperforms.
SMI’s Stock Upgrading strategy based on performance momentum is an excellent discipline that will help you overcome your inertia. Consider this illustration of how Stock Upgrading repositioned our model portfolios into more aggressive holdings, automatically, when the 2007-2009 bear market ended.
As the market was bottoming in early March 2009, Stock Upgrading was positioned in conservative funds. But as the new bull market unfolded, our Upgrading methodology weeded out the more defensively-oriented funds and replaced them with funds that would profit much more handsomely from the new market uptrend that was underway. By the end of 2009, 17 of the 20 stock funds from the March lineup had been sold and replaced. As a result of this structured selling process, the model portfolio turned in market-beating gains in both 2009 and 2010, outpacing the broad market by 7.0%.
Going back a bit further to 2007 (the year the bear market officially began), the benefits of Upgrading’s selling discipline become even more pronounced. Stock Upgrading actually managed a 10.1% gain for the 2007-2010 period — despite suffering the deepest bear market in a generation. In contrast, the overall market lost 0.3%. (Recent year-by-year performance results for all of SMI's strategies, as well as the overall market, can be found here.)
Creating the “Laggards List”
To encourage you to take a tough-minded look at your current fund holdings, we decided to prepare a list of “time to fold ‘em” funds, both load and no-load. I used the Morningstar database and instructed the software to retrieve performance information on U.S. and foreign stock funds, but to exclude index funds, foreign regional funds, very small funds (under $25 million in assets), and funds that didn’t have at least a five-year track record. The result was a listing of almost 2,500 hybrid and stock funds. Next, I grouped them into their respective risk categories so I could compare apples to apples as I put them through two tests.
The first test involved ranking them according to their most-recent one-year performance momentum. All the funds in the top half of each risk category’s rankings “passed” the test; those in the bottom half “failed.”
However, the past year has been a distinctly different market environment than much of this recent bull-market period. So for the second test I ranked all the funds again, but this time according to their most recent five-year performance. As before, I considered those in the top half to have passed and those in the bottom half to have failed.
To make my Laggards List, a fund had to flunk both tests. As it turned out, 862 funds earned this dubious distinction. These funds failed to perform in the top half of their risk category with respect to SMI’s momentum calculation (which covers the past 12 months) when the market hasn’t performed particularly well, and also for the past five years when the market was rising.
Due to space limitations, we can’t include the entire Laggards List here, but the 100 largest are shown at the bottom of this article. These are the ones most widely owned by investors, and by extension, investors who have been slow to take action when a fund needs to be sold.
The entire Laggards List of 862 is also available to SMI members (see the links below). Check it out. What you’ll find could be eye-opening, especially if you participate in a 401(k) plan at work. There are more than 90 target-date funds on the list. More than 75% of 401(k) plans offer participants the option of choosing such a fund. In many plans, a target fund is now the default option. Because of their ease of use (you simply pick the fund that has the year of your expected retirement in the name), they’ve become popular with plan participants. But all target-date funds are not created equal, and you should know if the funds in your plan have been consistent underperformers.
Time for a change?
If I owned any of the funds on this list, I would unload them now. Their absolute returns have not necessarily been bad, but in comparison to the other funds in their peer groups, they have been consistent also-rans in recent years. You can do better. The nearby table shows the difference in the recent five-year returns of those funds that passed both of our two tests compared to those that failed both.
Investors have a staggering $1.1 trillion in the funds on the current Laggards List. If some of that money is yours, it’s time for a change. I’m not saying the current laggards will never shine again. There are many funds on the list that have managers with excellent reputations. Some of them have been on SMI’s recommended list in the past. They may indeed return to the ranks of performance leaders down the road, and we’ll be happy to own them when they demonstrate they’re on top of their game once again. But in the meantime, doesn’t it make sense to go with funds that are better positioned for the current market?
You can use this as an opportunity to invest in one (or more) of our recommended funds. For each category where you need to make a change, start with the top-listed recommendation. If a recommended fund is available at your brokerage, contact your broker — online or via phone — to buy the fund(s) you’ve picked. An advantage of using no-load funds is that such changes are relatively easy to make. (If you’re in a load fund, you usually can move to another fund within the same family at no cost.) And if you own a “laggard” in your 401(k) or other workplace retirement plan, you can use our Personal Portfolio Tracker to determine which funds within your plan are better current alternatives.
Markets and market leaders change continually. It’s possible that within the next year or two you’ll find some of our current favorites on an updated Laggards List! Staying flexible and being ready to upgrade your holdings as the performance leaders rotate is the price you pay for better returns.
Viewing the full “Laggards List”
- The 100 largest funds from the Laggards List are listed below.
And if you're an SMI member, you can view the full Laggard’s List of 862 funds here.
- If you’re not already an SMI member, we've got good news for you!
We’d like to invite you to take advantage of a FREE 30-day trial membership. You’ll be able to view the entire Laggard's List via the link above, as well as test drive all the other great features SMI offers — the 401(k) Portfolio Tracker, all of our Premium Strategies, the Back Issue Library, the Message Forum, the monthly Fund Performance Rankings report, and more! And it’s all risk-free. If you decide not to continue your membership, just contact us before the end of the 30 days and you won’t be charged. Otherwise, do nothing and at the end of the 30 days we’ll begin charging you at the monthly premium membership rate of only $14.95 each month.
To take advantage of this offer, simply scroll down and click the red “Start My Free Trial” button that appears immediately after the list of funds below. Follow the rest of the free-trial prompts and you’ll be enjoying your new trial membership in no time. It’s that easy!
Even if you don’t plan to continue your web membership beyond the trial period, we invite you to be our guest and check out the full list of 862 laggards. For more than 25 years, SMI has helped tens of thousands become better stewards and investors. We’d like to help you too! Come and see the rest of what SMI has to offer. There’s no risk — your first 30 days are on us!