Sometimes, a fund does need to be sold

Dollars & Sense

November 23, 2003|By MORNINGSTAR.COM

I am trying to learn how to handle funds with disappearing stars in my tax-deferred retirement account.

If my fund once received four or five stars and now receives one star, should I just hold on to it since I won't be able to take advantage of any tax write-offs for the losses?

Or should I sell it?

-Laurie E.

It's never fun to abandon things you once loved. But there comes a time when it makes sense to give up on that formerly awesome TV series, those jeans that just don't look very cool anymore, or even that once-stellar investment. Read on to learn more about why you might want to sell your low-star investment - and why you might not.

I've discussed selling a fund in a previous article. But in her question, Laurie gave me a couple of constraints that made the sell decision more difficult. Since she's in a tax-advantaged account, she can't harvest the loss to offset taxable gains elsewhere in her portfolio. Moreover, although Laurie didn't specify what kind of retirement account she was investing in, if it's a 401(k), she might have only a limited number of other investment options from which to choose.

Laurie also specified that the fund in question lost several stars. Obviously, this fund has fallen on hard times. But that doesn't necessarily mean that it's a compelling sale. The important question that Laurie needs to answer first is: Why did my fund lose stars?

As a quick refresher, the Morningstar Rating for funds is an evaluation of a fund's risk-adjusted and load-adjusted returns relative to its investment peer group. Thus, it's a historical measure of relative performance and volatility.

Sometimes funds lose stars and remain compelling picks. One of the most dramatic examples I know is Vanguard Capital Opportunity (VHCOX). As recently as 2002, this fund boasted five stars over the three- and five-year periods and overall. But Capital Opportunity is also an unusual, concentrated fund with a huge technology stake. It struggled mightily in the last two years of the bear market and currently its three-year Morningstar Rating is only one star, and its overall rating has dropped to three stars. While the fund's recent gyrations serve as a reminder that the offering is volatile, quirky, and not well suited for conservative investors, it doesn't diminish our appreciation for the fund. We still appreciate its capable management team, unwavering approach, impressive long-term record and low expenses.

Thus, just because a fund loses a star or two doesn't mean you should feel compelled to sell. Star ratings shift around a bit over time and just as you shouldn't use a star rating as your sole reason for buying a fund, you shouldn't use it as your sole impetus to sell a fund either.

That said, a fund that drops from five stars to one star may be in quite a bit of trouble.

A big decline should at least drive you to answer a series of questions about your investment: Is the fund suffering through a (hopefully) temporary rough stretch because its style is out of favor? Or has the fund suffered material changes that cloud its prospects? For instance, has the fund undergone a deleterious manager change? Has the fund seen a significant increase in its expense ratio? Or has the fund undergone a series of strategy changes? If the answer to any of these questions is "yes," then you might want to consider selling.

Once you've addressed the star-rating concerns, though, there are a few other questions you should consider before bailing on a fund altogether. Not only will these questions help you decide whether you should sell, but they could help keep you away from inappropriate holdings in the future.

Was this fund the right investment for me in the first place? Sometimes investors overestimate their tolerance for volatility, especially when they buy into a fund that's notching huge gains. If you find that you are selling out of a fund because you can't handle the losses, make sure you internalize that lesson and avoid making the same mistake in the future.

Does this fund fit into my portfolio and serve my overall investment goals? Regardless of whether your fund boasts five stars or one, you should think about how it fits into your portfolio. For instance, if you own a mediocre technology fund and a good, diversified growth offering with ample tech exposure, then it makes a lot of sense to sell out of the tech fund.

What are the costs of selling? To consider the opposite scenario from Laurie's, what if you incur capital gains from the sale of fund? Are you still interested in selling in the face of a big tax bill? What kind of sales fees or commissions will you have to pay? Of course, if a fund is troubled enough, you might well want abandon it - even in the face of tax consequences and transaction costs. But you should at least be aware of the costs incurred by selling.

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