Time to Sell Strong Funds?

A reader questions the logic of selling a well-performing Strong fund amid the industry scandal.
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I own Strong Advisor Small Cap Value Fund, and it has been one of my best mutual funds. Should I think about selling it, out of worry that there may be redemptions that will screw up the way it is managed, or because Mr. Strong has stepped down and he may have been a key person in the fund's success?

Also, my partner has a lot of money invested in Putnam funds. Is it advisable to sell those funds because of the effect of the many redemptions? If so, is time of the essence? I do not care about the ownership of the fund managers, just the effect on the performance of the funds they manage as an investor in those funds.

Neal W.

Dear Neal,

There's no need to panic -- although now is a fine time for investors to take a close look at the funds they own and why. Eight fund companies have been named in New York Attorney General Eliot Spitzer's investigation of the industry, and dozens more have been subpoenaed by the

Securities and Exchange Commission

.

Allegations of illegal or improper trading have been levied at fund management groups

Fred Alger Management

,

Alliance Bernstein

,

Janus Capital Management

(JNS)

, the Nations funds operated by

Bank of America

(BAC) - Get Report

,

Bank One's

(ONE) - Get Report

One Group funds,

Prudential Securities

and -- most notable of late --

Putnam

(a unit of

Marsh & McLennan

(MMC) - Get Report

) and

Strong

funds.

Strong and Putnam are particularly egregious examples of abusive trading practices -- in both cases executives themselves were the alleged culprits. (In other cases, the firms were accused of simply being complicit in allowing others to trade their funds improperly.) While the

(SMVAX)

Strong Advisor Small Cap Value fund has consistently beaten the category average since its inception in 1998, the charges against Strong Investments seriously curb the appeal of this fund.

This quantitative fund was managed by Charles Rinaldi and not specifically named in Spitzer's charges. So sure, portfolio managers do matter, but when the investment management company appears to put the profitability of the firm (and its executives) ahead of shareholder interests, it's hard to make the argument to stay put, despite the fund's more-than-respectable history. The same goes for other Strong and Putnam funds.

Because the value of a mutual fund is inherently determined by the fund's holdings, redemptions won't cause a downward spiral, as in

Enron

shares. But large redemptions -- of which we're already seeing much of in these funds -- certainly take a toll on fund performance.

First, the trading costs of redemptions essentially get passed on to existing shareholders -- not paid by the exiting ones. Second, redemptions often force fund managers to sell holdings they would otherwise like to keep. Such internal churn nearly always increases the tax burden on the fund, and generally disrupts the overall portfolio management.

So while there's little reason to hold onto funds operated by firms you no longer have faith in, don't sell simply to "send a message." Rather, carefully consider where you want to deploy your money, given your risk tolerance and asset-allocation plan.

In addition to choosing the type of investment you're replacing your Strong and Putnam investments with, evaluate the type of firm that manages the funds you're considering. Putnam has long had a history of erratic and abrupt manager changes, while Strong has had numerous run-ins with federal regulators over the years.

Also, before you sell, keep your own tax strategy in mind. Selling this close to the end of the year means you'll receive an almost immediate tax impact. That can be a big wallop if you're selling a fund that has (perhaps for the first time in several years) turned a profit.

If you're sitting on big gains, consider selling some now, and some in the new year. If you're selling a fund at a loss, remember that you can only offset $3,000 of ordinary income with any losses that exceed the amount of gains you reap in that year.

While we're still months away from knowing just how systemic these improper trading practices are in the fund industry, a little due diligence now will ease the potential pain of selling and hopefully minimize the chance you'll have to go through this again.

Have a question for Bev on personal finance, tax or mutual fund matters? Write to her at beverly.goodman@thestreet.com.