A question often asked is how do you know when to sell a fund? What follows is a personal view, and might not be representative of what goes on in the real world, which in this context can be described as the aggregate actions of all fund investors who have an interest in markets.
I’ve always started from the premise that any damn fool can buy a good fund, but it’s much harder to sell one.
A large proportion of fund investment and sales tends to migrate towards the stars of the day, on the basis that new investors identify with the halo of skill the manager demonstrates and that the outperformance the fund has achieved in the past will continue. But the persuasive part of this decision is based on what is already known, rather than any objective assessment of whether the market context has changed from the one in which the past good performance was achieved. Potential new investors should therefore ask themselves whether they have any useful insight into what might happen next, and whether probability is on their side?
Facts not Fancy
At this point one can quote two facts, one quite well known, and one perhaps a little more obscure.
The first is that fund performance tends to degrade over time. Thus, in a reasonably homogeneous peer group, among the top performers from say five years ago, only a small proportion are likely to be doing well today. The commonly used 5-year analysis period is crude and there will be phases when it should be longer (or shorter). However, the underlying implication that a fund investor should be open to being active is clear. Sadly, often they are not, usually because of the power of inertia.
There are numerous reasons why performance degrades. Here are three of the most common ones. First, over time top performers tend to attract large investment flows. However, the fund eventually becomes a victim of its own success and grows too large to operate effectively with its chosen strategy, usually because the natural opportunity set diminishes.
Secondly, although investors trust the manager to react to changing circumstances, market leadership often moves faster than one can reasonably expect a fund process to evolve, and this is critical since most funds have a signature or investment style that doesn’t alter much.
Thirdly , following a period of success, the demands of employers may grow, while many managers become over confident in their ability whilst ignoring their shortcomings. As the Greeks observed over two millenia ago, ‘hubris’, or excessive pride, often leads to a downfall. In broad terms, this means that if you hold a fund, and you don’t understand the nature of the strategy, in what circumstances it should do well or badly, or if you spot some of these danger signals, then perhaps it’s time to move on.
The second fact is that the returns investors actually achieve often lag behind the averages of the funds they invest in. Based on data derived from mutual fund investors in the US, studies by Morningstar and others have shown the shortfall, which varies across different sectors, can be as much as 1 -2% per annum. One would hope that disciplined, institutional investors and other investment professionals produce better results, but I wouldn’t assume it without question. This research shows that fund investors time their activity badly, driven by the twin apostles of fear and greed. To put it simply, they buy high and sell low. Part of this is probably just a reaction to general market conditions, but I suspect this also results from selling funds after a period of poor performance (although I find this description unhelpful), just prior to a meaningful recovery.
So how does one know when to hold? Unfortunately, there are no hard and fast rules, but time spent with managers and getting to know them, particularly during periods of stress, is invaluable. One example of when to hold is where you are sure the manager is continuing to do ‘what they say they do on the tin’ while suffering a negative high standard deviation event, and they haven’t capitulated in the face of market or management pressure. This is a technical way of describing a large performance differential between the fund and its benchmark, relative to one of many risk measures. If there’s been no change in the underlying fundamentals, you believe in the concept of mean reversion in markets, and can think of a reason or catalyst why the market regime could change, then selling a fund in these circumstances is likely to be a poor decision. Indeed, you may do very well by holding on, or even buying more.
At this juncture I should mention that I’m also a strong believer in the power of momentum, because it’s based on animal spirits, although with some financial purists it has all the credibility of some odd religion. Momentum, which is about holding winners, and selling losers, is the enemy of mean reversion (except when there’s a ‘momentum crash’ when losers can actually do quite well). The important point here is to recognise that it exists and therefore, if you own a fund that’s done really well due purely to the price behaviour of a group of securities that are strongly related in some way, then you should at least be aware of the reason. There have been numerous examples when I’ve seen a fund performance accelerate sharply upwards, far beyond what I had predicted as a performance expectation. The manager is probably feeling clever and you are feeling good. Momentum as a risk factor is something that can be measured in a portfolio, and if the reading as percentage of overall risk is very high, then beware. It may well be time to act.
In this blog I have purposely tried to avoid discussion of what to do as the organisational framework around a fund capability changes. The most common and obvious response you’re likely to see is ‘I’m selling because the fund manager’s gone’. That seems too simplistic and to quote Aristotle, ‘the more you discover the less you know’. So, if you have time at your disposal and spend your days analysing funds, the reality of analysing people, whether they be the portfolio managers, research analysts, or their bosses, is complex, and can best be likened to wading through treacle. A re-occurring observation I make is that two different, highly experienced fund analysts presented with exactly the same facts, might come to polar opposite conclusions. My best advice is follow your nose, but don’t rely on one or narrowly focussed decision metrics. Its highly likely there’s something you’re missing. One of my favourite lines comes from the film, Butch Cassidy and the Sundance Kid: ‘there’re no rules in a knife fight’ The same should probably be true of all fund selection.
About Jon Rebak
Jon has nearly 40 years’ investment experience, having worked for HSBC and its prior companies in a variety of investment and research roles, but specialising in collective funds research and management and understanding them in a markets context.Jon was one of the founder members of HSBC’s global multi-manager team in 2000. | December 2018