This week's question is:
How long do you recommend holding an investment in an underperforming 401(k) fund?
And, what fund performance measurement(s) do you recommend using to make this
decision?
Translation: "How do I tell if my fund is a dog?"
Indeed, this is one of the toughest investment questions around, for two reasons.
1.First, it's hard to determine the cause of the poor performance -- a misguided
analytical
process, which is likely to cause poor performance in the future? Or unfortunate stock
choices within a solid investment management discipline?
2.Second, selling a fund means admitting to yourself -- and worse yet, to your spouse --
that
you may have made a bad decision when you initially chose the fund.
Step number one: measure performance
Before passing judgement on whether a fund is a dog, you first need to determine how to
measure
performance. You should never judge a fund based on absolute performance, because returns
are
dependent on the concurrent market conditions.
The easiest way to gauge relative performance is to compare the fund's returns to its
benchmark. A
better, but more time-consuming, way to analyze performance is to compare the fund's
return to a
group of its peers. There are statistical procedures to measure performance, too, but
those are
probably best left to the professionals (for example, at 401kForum, we calculate
"style-adjusted
return," but it's a relatively time-consuming process using custom-built software).
Once you've measured performance and determined that it's low, deciding when to "kick
the dog
out" depends on three aspects of that low performance -- magnitude, consistency, and
context.
For example, I get concerned when a fund is lagging its peer group by more than 1.5% per
year and
has been doing poorly for several consecutive quarters, and there is no rational
explanation for the
low returns.
Step number two: decide whether to focus on past performance
But keep this in mind: the only reason to focus on poor past performance is because you
think it has
something to do with potential future performance.
Outside of giving me insight about what might be happening going forward, I don't really
care about
historical performance -- it's all water under the bridge, spilled milk, yesterday's news,
and several
other clichıs that escape me right now.
So as you consider how long to hold a poor performer, remember that you should only care
about
the aspects of poor performance that are likely to be persistent. If you don't believe
your funds' past
performance will be related to future returns, then you should merely send thank you notes
to your
good funds and place curses on your bad ones, but not adjust your fund line-up in any way.
Step number three: look at events surrounding the performance
I do believe that past and future performance are related, although the relationship may
not be as
strong as most people think. My research shows that if you look at fund performance over a
three-year period, funds that earn returns in the top 25% of their peer group are 50% more
likely to
do well during the subsequent three years than a fund that was in the bottom 25%. So it
takes three
years to identify the bottom feeders in the investment food chain.
Should you wait three years to get out of a fund that is performing badly? No -- you can
speed up
the process by looking at the context surrounding the poor performance. Ask yourself the
following
questions:
Does the fund seem aware and forthright about the reason for its low returns? In letters
to
investors, in publications, and in responses to phone inquiries, does the fund management
directly acknowledge its problems, or act like my son does when I ask him who ate that
last
cookie ("Who me")? Similarly, what actions has management taken to make sure the
problems don't occur again? I much prefer a manager who admits making mistakes to one
who covers them up.
Were the actions that caused the fund to do poorly consistent with your overall objectives
in
investing in the fund? If not, sell the fund. If an equity fund did poorly because it put
some
money in bonds or money markets, I would get out. Likewise, if a fund that claimed to be
well diversified lost money because it invested an abnormally large amount in Internet
stocks,
I would consider exiting the fund.
Have other circumstances about the fund changed from the time you first invested in it?
For
example, if a poorly performing fund has recently changed its objectives or management,
there is better reason to sell than if those factors have remained constant.
Of course, these are just guidelines to help you make a decision. There are no firm rules
about the
ideal time to dump a fund (if there were, everyone would be dumping funds on the same
day).
Finally, worry about performance that is "too good"
In conclusion, I'll interject some controversy. I proclaim that a good time to get rid of
a fund is not
only when the inappropriate actions cause abnormally bad performance, but also when
inappropriate actions cause unusually good performance! Why? Because outstanding returns
generated for the wrong reasons tell me the fund is taking risks that are not consistent
with my
desires. I would rather sell the fund and lock in the good returns, and invest in a fund
that is more
consistent with my goals.
So when a fund betters its benchmark by shifting money into different asset classes,
taking an
undiversified position in a stock or an industry, or changing its investment objectives,
that's my cue
to sell. I consider myself fortunate that the additional risk helped me, but I don't take
the chance that
the fund, and I, will get lucky again.
Then I tell my wife that the reason for the abnormally high return was my superior insight
in picking
the fund. Yeah, I feel a bit guilty, but it gets me out of doing the dishes for a few
days.
 Lummer's
Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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