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FUND INSIGHTS
When Not to Ditch a Fund
by Ken Gregory & Steve Savage
Should poor performance trigger the sale of a stock mutual fund? Not always. Even great stock pickers blow it from time to time -- but not because they suddenly wake up stupid. If you decide to sell a loser, come to that conclusion only after digging beyond the performance problem. Rationally assessing fund performance requires you to accept the fact that even the best people in this business can make mistakes or get out of sync with the overall market. Good, then horrid
To drive home this point, we looked at Morningstar data going back ten years and, using some common-sense constraints, screened for top-decile performers in the large-company growth, value and blend groups. We then counted the number of calendar years in the past ten that each of these long-term winners really struggled, as defined by a bottom-quartile performance in their category. The percentage of years in which the average top-decile fund fell to the bottom quartile ranged from 14% to 20% across these categories. Combining the value and growth categories, exactly one-third of the funds were in the bottom quartile at least three years out of ten. These included the long-closed and legendary Sequoia fund as well as highly regarded Clipper and Torray funds.
Looking closer, there are some very telling stories. From April 1995 through December 1999, Longleaf Partners slumped. There was no wipe-out year, just three below-benchmark years and a couple of average ones. Over the period, the fund delivered an annualized return of 16%, but the Russell 3000 Value benchmark compounded at 21%. Over the next three years, Longleaf more than turned things around, returning an annualized 11 percentage points more than the benchmark.
Brandywine suffered a very tough period from the end of September 1997 through February 1999. This included the fund's much criticized move to cash in late 1997 and its subsequent move back to a fully invested posture just in time for a market correction in 1998. During this period, its annualized return was -12%, versus a blow-out 25% for the Russell 3000 Growth benchmark. Sticking with Brandywine was a tough call. But investors who gave up and moved to another growth fund missed out when Brandywine returned an annualized 16 percentage points in excess of the Russell in the following three years. Brandywine even managed a positive return in 2000, the year when tech stocks began their meltdown.
Clipper went through a lengthy slump, from May 1997 through March 2000. Over almost three years, it compounded at 10.5%, versus 16.9% for its Russell 1000 Value benchmark. But in the next three years, Clipper more than made up for its shortfall. Oak Value, Baron Asset and FPA Capital are other well-run funds that fell into ruts but subsequently climbed out of them. In every case, except for Longleaf, the funds experienced sizable redemptions usually just as they were about to begin a huge recovery.
What to ask
How to know whether your fund's performance is cause for concern? Consider the question from two directions. First, what gave you confidence to buy the fund in the first place? Has anything changed? If you invested because of past results only, shame on you. Performance is just a starting point. You must also ask, Is the management team really good? Does it have a well-articulated process, and is there some way to verify that the approach is executed in a disciplined fashion? (See our August 2004 column on how to pick a fund.) Changes that might justify a sale include clear evidence that the manager is straying from the process; departure of key people who are replaced by unknown quantities; distractions from new funds or more marketing responsibilities; or asset growth that hinders flexibility. Absent major changes, if you did your homework when you bought the fund, it's hard to justify selling after only a year or two of below-benchmark returns.
The other consideration: Does it even matter how a fund compares with a benchmark index or its peer group over periods of a year or less? If not, then why penalize the fund for poor relative performance? Just think of the discrepancy as little more than a tracking error. We strongly prefer managers who ignore benchmarks and follow their investing process wherever it takes them. This keeps them from being constrained by artificial style parameters and allows them to focus on holding the stocks that they believe have the most potential.
Skilled stock pickers are highly disciplined and believe in their own analysis. Mistakes often only partially explain a performance slump. The market may, for the moment, be punishing several of the fund's key holdings. Good stock pickers will redo their analysis and re-question their thesis on each stock. But once they've done that and remain convinced that their analysis is correct, they don't fold their cards just because the market disagrees -- indeed, they may well buy more, which is why big slumps can lead to big recoveries.
In a slump
Shareholders of Longleaf Partners, Oak Value and, yes, even Legg Mason Value (run by the man who has bested the S&P 500 for 13 consecutive years) may be disappointed. All three are lagging their benchmarks in 2004 and rank quite low relative to their peers. But more important, because we follow all these funds closely, we continue to have confidence in each. History suggests that we shouldn't be surprised if their "slumps" are followed by stellar relative returns.
Ken Gregory is president and Steve Savage editor and publisher of No-Load Fund Analyst newsletter. Their firm also serves as adviser to the Masters' Select funds. |
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