If your mutual funds lost 40% last year, should you sell?
Millions of fund, 401(k) and IRA shareholders must answer that question. Of the 3,825 domestic equity funds tracked by Morningstar, 1,305 lost more than 40% in 2008. The damage was particularly severe for growth funds. The average midcap growth fund dropped 43.8%, while small growth declined 41.6%.
Seeing the red ink, investors are dumping shares at a record pace. But before you make any trades, compare your funds to those of competitors. Look at factors such as fees and pay special attention to performance records. If a fund has delivered above-average returns in recent years, you should consider keeping it. Even though they suffered losses, many strong performers have demonstrated they can survive horrendous conditions. Such warhorses could produce solid results when markets finally rebound.
While investors should never pick funds based solely on past performance, there is substantial evidence that a track record is an important indicator of future results. Consider research by Roger Ibbotson, a Yale professor of finance and founder of
Ibbotson divided funds into categories, such as small value and large growth. He found that when a fund outdid most peers for two consecutive years, it stood a 55% chance of repeating the performance in the next 12 months. Ibbotson found evidence that the odds of success improve for funds with greater outperformance. So if a fund lands in the top quarter of its category for three years, it stands a 59% chance of beating the group in the following year.
Ibbotson did his research in the 1990s, a time of benevolent markets. His work could be even more relevant today when funds face enormous turbulence. Any portfolio manager who has landed in the top quarter of the field for the past three years has truly proven his mettle because conditions have changed dramatically from year to year.
In 2006, markets favored large value funds, which returned 18.2% for the year, more than 10 percentage points ahead of large growth and 2 points better than small value. So a manager who favored large value stocks could have thrived simply through the luck of the draw. Among large value funds, those focusing on giant stocks had an advantage over competitors who did not hold the biggest companies.
The next year, the tables turned, as large growth funds returned 13.4%, more than 11 percentage points ahead of large value and 19 percentage points better than small value. To have prevailed in both 2006 and 2007, a large value manager likely needed some special skill.
Then came the turmoil of last year. All categories sank, but small value emerged as the winner, outpacing large growth by 8 percentage points and large value by 5 points.
Who passed all the tests? Among the 416 large value funds tracked by Morningstar, 17 finished in the top quarter of their category for all three years. Many of the winners emphasize high-quality dividend-paying stocks, which often prove resilient in difficult markets.
A top performer is
Cullen High Dividend Equity
. Portfolio manager James Cullen favors steady businesses with little debt. A top holding is
, which has solid profits and a dividend yield of 4.6%.
Another consistent choice is
. The fund avoids troubled turnarounds, focusing instead on companies with strong balance sheets and secure niches, such as
. The defense contractor should report steady profits, even if the recession worsens.
For a steady large growth choice, try
Sentinel Growth Leaders
. Portfolio manager Elizabeth Bramwell favors reliable companies that have relatively low prices. A big holding is hamburger chain
, which is enjoying steady sales. By holding such predictable stocks, Sentinel should be positioned to survive downturns and lead the pack when the markets finally revive.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.