The Retirement Corporation of America

Putting Your Funds Through An Annual Review

THOSE QUARTERLY REVIEWS of fund performance are meant to keep you focused: watching your investments closely enough that you always have a clear idea of what you own and how well it is performing. Keep each quarterly review in a file folder, so you have a running record of how well each fund is doing and how well your overall fund portfolio is performing. You don't want to act on the basis of one quarter's performance results. Yet again, you are a long-term investor, building around your financial plan.

So how often should you give your portfolio the kind of careful once-over that could lead to selling some funds, buying others and making wise decisions about where new money is to be invested?

Do a thorough review of your mutual funds—indeed, of all your investments—once a year. Best time to do it is around the end of the year when you know how each investment performed for the year—by itself and in comparison with other investments of its type.

What to Look for In Your Annual Fund Review

Don't just look at annual performance figures and make shoot-from-the-hip decisions based on them. One year's performance may not be a true test of a fund. Performance figures, taken by themselves rather than compared with other funds of its type, don't mean much.

Most important, there are many things to look at in addition to annual performance. A fund could turn in a banner year and yet have deep-seated problems that should cause you to pause before adding new money and maybe even think about selling.

So here are the 10 Indicators That Should Put a Fund on Your Warning List:

1. A fund's performance lags behind its peers' for more than two years. When any of your funds aren't performing as well as comparable funds, you have every reason to be concerned. None of your funds will perform as well as you would like every year. But two years is long enough to hang onto a dog when there are better choices in the same category.

2. A stock fund becomes too aggressive for your taste. Maybe you bought a stock fund that only had a small exposure to emerging markets. But now, the manager has decided to double the fund's investments in those markets. And that makes you nervous. Sell the fund and buy one that restricts the percentage of fund assets the manager can allocate to emerging markets. This became a particularly serious problem at the turn of the century as technology and the Internet caught fire. Even conservative funds began selling off sluggish blue chips and overweighting on the hot stocks of the day. Review the list of stocks the fund owns. Are all the names familiar? Are they all stocks you would feel comfortable owning if you bought them directly? Check out Morningstar for the fund's beta—how volatile it is compared with other funds of its type. If the fund has changed its spots, you have to consider whether you want to continue owning it or shift to something more your speed.

3. A stock fund gets too big. The larger a stock fund gets, the harder it becomes to manage effectively. The money pours in but at times so fast there aren't enough places to put it. So, the manager has to keep more of the fund's assets in cash until it can be invested and performance starts to suffer. Moreover, the bigger the fund, the less likely it is to outperform the market because it owns so many stocks.

4. The manager of a hot fund leaves. If you picked a fund because the manager had an excellent track record, only you can decide how willing you are to give the new manager a chance. One year is reasonable if your returns hold up. But if they're down significantly after 18 months, start looking for another fund. The fund's literature will report on a change in management. If the fund is big enough, or has had unusual performance, a change in fund management will be reported in the press.

5. The fund's expenses have increased. Whatever you pay in expenses—the fee the fund charges for investing your money—it comes right out of your return. With funds getting bigger, common sense tells you expenses should be coming down because of economies of scale. Greed being what it is, many funds have increased their expenses—taking money out of your pocket. Check the expense figures in fund reports, in reports from Morningstar, and in other fund rating reports you see. Again, there is no obvious reason for expenses to top 1% for a bond fund, 1 1/2% for a domestic stock fund and 2% for an international fund.

6. The fund is trading too often. You don't want a fund manager who buys a group of stocks and then sits on them forever. Times change. You are reviewing your fund investments because some may not have performed up to snuff. You want the fund manager to do the same with the securities he or she owns. So some trading by the fund is good, but too much is bad. First, each trade rings up a commission charge—adding to fund expenses. Second, frequent trading tends to reduce, not enhance, fund performance. Third, each sale by the fund sets up a potential tax liability. That liability is passed directly to you. Funds, and those who rate them, report on "turnover"—the percent of the portfolio that has changed over the past year. The higher the turnover rate, the more you are exposed to high expenses, weak performance and the potential of high tax bills.

7. A fund shrinks dramatically. If the shareholders of one of your funds start leaving in hordes, there's probably a good reason why. If it isn't evident in the fund's performance, you should ferret out what the problem is. It could be because a good manager left or simply because many investors think changing economic or market conditions will hurt that type of fund. Look at other funds in the same category to see if the whole sector is losing more shareholders than it's gaining. That will tell you it might be time for you to consider making a switch too. You'll find redemption figures in your fund's quarterly report and annual reports. Compare them with industry-wide figures for the same period. The Wall Street Journal and Investor's Business Daily publish them regularly. So do some personal finance magazines. If your fund has net redemptions—more sellers than buyers—for several quarters while similar funds don't, it's a red flag. Meanwhile, if the fund is buying back more of its shares than it's selling, its assets are shrinking. That means its expense ratio will go up because there are fewer shareholders to pay the freight. That could lead to more net redemptions.

8. It's too much like another fund you own. You diversify your investments for a very good reason—so your risks are spread out so broadly that a hit in one area won't wipe you out. You wouldn't own a portfolio comprised totally of small-cap growth funds. Neither should you own funds whose portfolios overlap—each owning essentially the same mix of stocks. As a worst-case scenario, you might own two or three funds, each of which owns the stock of your employer. But you also own the stock through your 401(k) plan and maybe still more of it through a discount stock purchase plan. Don't just diversify into an array of funds. Read the list of fund holdings to make sure there isn't too much overlap—not only of investing styles but of the investments themselves.

9. It is sticking you with hefty tax bills. Mutual funds must pass along all income to you—dividends paid by the securities they own and capital gains earned when a stock or bond from the portfolio is sold. Along with the income, comes the tax liability. The more a fund trades, the more likely it is to generate taxable capital gains which you must pay. A fund can sell heavily during a bad year—sticking you with a huge tax bill even though the fund's net asset value actually declines during the year. Some funds (index funds especially) do little trading and don't stick you with big tax bills. Your tax returns will show you which funds hit you with hefty tax bills. All things being equal, favor funds that don't burden you with tons of taxable capital gains.

10. You honestly can't explain why you own the fund. To succeed financially, you must have an investment strategy. That means buying the right mix of funds to suit your financial situation, time horizons and risk tolerance. But we all act on whims. Maybe you bought this fund because it made the cover of a magazine or a friend told you about it. Maybe a stockbroker or a financial planner persuaded you to buy it. Don't automatically sell the fund—especially if its performance has been good. But be wary about adding to your holdings and mark it as a candidate for potential sale in order to get back to your basic investment strategy.

What to Do When the Numbers Don't Add Up

The more of those 10 indicators that apply to one or more funds you own, the more reason for putting them on your warning list. What you do then is up to you.

•  Don't jump the gun on poor performance. Give the fund two years to deliver the kind of return you were anticipating when you bought in. Only after two years should you consider selling.

•  Don't consider a fund that, for one reason or another, is on your warning list as an absolute candidate for sale. As long as the fund is on your warning list, you probably don't want to add any more of the fund to your nest egg.

•  Be leery when the fund gets too big or its strategy changes or expenses go up. Any of these changes should make you cautious. But if performance continues to be what you were hoping for, then hang on for another year—and keep your watch.

•  Be very leery of a fund whose investors are deserting in droves. That can drive expenses up, force the fund to cut back on investment analysis and generally make the fund less desirable to own. A fund with a severe case of the "dwindles" may become a candidate for immediate sale—unless you have some good reason to think the shrinkage is only temporary.