Contributed by: martingale
 The Globe & Mail is running a story on when you should sell a mutual
fund that has been underperforming:
The article investigates several funds which have "underperformed" as
a way of illustrating how you might analyze your own funds. There are
several gross errors in this analysis that investors ought to be aware of.
This article suggests that investors who "buy and hold forever" are
somehow fools--which may just be an attempt to fool you into churning
your money, earning transaction fees for companies that advertise
in the Globe & Mail.
Standard investment theory has it that you should periodically
rebalance your assets. That means if something has declined in
value you should add more money to it. But, flying in the face of
that conventional, standard advice we've got the financial press
promoting the idea that you should sell your losers. Let's see
what's gone wrong.
First, and most blatantly, the article never mentions fees. The most
common reason why a fund would underperform its peers is that its
manager is pocketing more of your money. Actively managed funds
generally have fees ranging from 2 to 5%. Given that the expected
return of the stock market is only 8-10% the manager is going to
pocket somewhere from 20 to 50% of your profits.
Second, the article analyzes the past performance of various funds
by looking at their overall performance and their consistency:
"short-term momentum that suggests a rebound". Nobody should ever
make an investment decision based on short-term factors, nor should
anyone ever consider past performance:
past
performance is no indication of future returns.
There's an even worse problem with this analysis: The article
seems to suggest that a fund with a more "consistent" history might
have a better return in the future when it says you should "compare
your fund to others in the same category in terms of long- medium-
and short-term performance and on year-by-year consistency". What
does determine the performance of a fund is whether it
holds higher or lower risk assets. Riskier assets have a better return,
but they are not consistent (that's the definition of "risk" by the way).
If you want to pick a fund with a higher return pick the one that has
been the least consistent--the opposite of what Carrick says.
Now you might not want to take a risk (such as if you are retired and
you need the money) but you should certainly understand this principle.
Carrick seems to be suggesting that you can find higher return, lower risk
funds and there is absolutely no such thing. The danger here is that if you
follow Carrick's advice you may sell your "inconsistent" assets when they are
low. Investors who fall in this trap will likely wind up buying a riskier fund just
after it has had a good run up (and it is high) and then turn
around and sell it when it has a few bad years (and is low). The
idea is to buy low and sell high, so this is exactly backwards.
Finally, I have to take issue with one statement: "If you invest
$1000 and lose 25 percent, it takes a 33-per-cent gain just to
break even." All securities are always fairly priced. A fund
that has fallen by 25% is now priced at a fair value--even if
that is a loss for you. Thinking about "breaking even" in this
case is just the wrong way to look at it. The money you used
to have in the fund is gone; your current investment in the
fund is as "even" as it ever was or will be.
Here is some advice on when to sell funds: If you are paying a
fee more than 1% you absolutely should sell; if you are paying
more than 0.50% you should seriously think about selling. If
you are paying less than that you should sell when you need
the money, or if you need to rebalance. | 
