By Scott Lummer
Chief Investment Officer, mPower

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 mPower, 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.