Mutual funds: Should you hold or fold?

One of the most difficult decisions for mutual fund investors is when to let go. Funds are notorious for turning around and having a great year the moment you kick them out of your portfolio.

The problem can be complicated when financial advisors recommend dumping funds that are underperforming. Sometimes the advice is well founded. But sometimes it’s just a matter of shaking things up to placate an unhappy client.

Reader’s dilemma
Consider this question I received from a reader:

“I have recently changed financial advisers and my new one is recommending that I sell quite a number of my mutual funds. All of these funds are worth less than I paid for them. Most of the funds that I have were rated highly in 1998 or 1999 when a CFP (certified financial planner) assisted me in buying them. Some of them are aggressive growth funds. If there is any reasonable hope that these funds might recover, I do not want to lock in a considerable capital loss. I don’t think the new adviser is trying to churn as he is not paid on mmission but on salary, and he sells funds at 0 per cent front-end load. Can you please give me some guidelines to follow?”

Make overall plan
Many fund investors face exactly this dilemma, because portfolios tended to be overweighed towards aggressive growth funds during the go-go markets of the late ’90s. If you’re in that position, remember one key principal:

The first step:

  • Do a full personal analysis to decide which type of funds you want to hold and in what proportions.

You should construct a model portfolio that you will always use as a base, and that you can constantly refer to as your touchstone.

  • Make sure the model fits your particular objectives, risk tolerance, etc.

An ideal portfolio will consist of a U.S. and Canadian money market fund, a Canadian and a foreign bond fund, and a growth and a value fund for each of Canada, the U.S., and the international markets.

  • Decide on the allocation percentages for each.
Next page: Winnow out funds

Winnow out funds

  • Assess your current fund portfolio in the context of your model.

See which funds you own that don’t fit, or that are redundant because you already have one or more of the same type. (You only need one fund of each type you want to include. For example, include one Canadian equity fund that uses a value orientation and one that uses a growth orientation.)

Those are obvious candidates for selling.

  • You only need 10 core funds to cover all the basic portfolio groups that I suggest.

Analyze current funds
The next step:

  • Analyze each fund you currently own. For example, is your Canadian value fund a good performer over the long haul?

By that, I mean does it show above-average returns over time, with average to below average risk? Check my 2002 Buyer’s Guide to Mutual Funds or go to the Globefund Web site to find out.

If the fund is consistently in the top half of its peer group, keep it regardless of recent performance.

If it is not, make a change.

  • Repeat the process with the rest of the funds.

You’ll end up with a portfolio that is perfectly suited to your needs and which should produce above-average returns over time with below-average risk.

Remember, it’s not a matter of simply selling some funds and replacing them with others. It’s a question of getting the right portfolio mix and then choosing the funds that best fit. 

Adapted from an article in April 2002 edition of Mutual Funds Update