The Globe and Mail, Report on Business
Published June 9, 2007

One of the reasons I’ve recently focused my career on the individual investor, after years of working with pension clients, is because there is a huge disconnect between their understanding of what investing is all about and what the reality is.

Even well-educated investors often have unrealistic expectations. Their time frame is too short and they think their fund manager can be at the top of the standings year after year.

Given that my partners and I recently started a new mutual fund company, you may be surprised by the question I’ve chosen to illustrate the gap between expectations and reality: When should you sell a poor-performing fund? It’s not something that fund company executives, such as myself, typically want to talk about. But I encourage investors to assess our funds, and any others, using the criteria presented here.

Before we get to the sell criteria, however, let’s try to understand why a fund might be lagging. It might happen for good reasons (hold the fund or buy more) and bad reasons (sell).

On the good side, a fund may be underperforming because its purpose doesn’t call for it to do otherwise. Many funds have a specific objective or specialty – steady income, low volatility, exposure to a specific industry sector or asset class – that often leave them out of synch with the overall markets.

At times they might be shooting the lights out in their specific niche, but performing poorly against the market.

Too many investors think that their fund managers have it all figured out, but they don’t. Take it from an insider - the investment world is far too complex for that. At best, managers make well-researched decisions based on what they think will happen. Call them educated guesses. If they get it right 60% of the time, they’re probably a superstar.

It’s like basketball in this regard. Even Steve Nash misses roughly half his shots. And he can look down right bad some nights, which leads to my point here. Like athletes, fund managers have slumps.

Insiders also know that portfolios can get stale. Stocks that have done well in the recent past and carried the portfolio to the top of the standings get fully priced, or over priced. As much as the manager might try to reduce the fund’s reliance on these stocks, the reality is that it takes time and guts to do. It’s hard to the sell stocks that have put a halo around your head.

Now, let’s get back to the question at hand. When do you sell?

First of all, there are some bad reasons for selling. You shouldn’t sell a fund solely because it hasn’t done well in the past couple of years and you want something that is doing better. This is called performance chasing and it is the surest route to disappointing returns.

Related to my earlier comments, a fund that is delivering on its specialized mandate shouldn’t be sold unless you no longer require that type of investment. Nor should you sell a fund that is going through a tough patch if it still has a good long-term record and the manager and investment approach hasn’t changed.

But there are a number of factors that should cause you to sell.

If the medium to long-term returns are poor despite a favourable environment for the fund, it’s time to act. An example of this would be a value-oriented equity fund that performed poorly in the weak markets of 2001 to 2003.

You should consider selling if the fund manager (i.e. the one pulling the trigger) has changed. This happens more than fund companies like to admit. In general, if there’s a lot of turnover on the investment team, it’s not a good sign. You end up in a situation where the people that established the philosophy and built the long-term record aren’t there.

One of the most reliable sell signals is when a fund, and/or manager of the fund, gets really big. It’s perverse, but in the investment management industry, too much success is a bad thing. In the Canadian market particularly, there is a profound difference between managing hundreds of millions and multibillions.

You should always be wary when the mandate and/or name of a fund changes. It is often a sign of desperation and lack of stability. With a change, the fund company may be trying to catch on to a current trend or is just hoping to solve a nagging problem. In recent months, quite a few funds altered their focus and added the words “dividend” or “dividend income” to their name.

Finally, if the fee is too high, you have the best reason to sell.