Kevin E. Donovan, CFA
Kevin E. Donovan, CFAPortfolio Research Director

At CJM, we utilize mutual funds and ETFs (Exchange Traded Funds) as investment vehicles to help our clients achieve their long-term goals. Far from employing a set-it-and-forget-it mindset, we continually evaluate the funds we use to determine whether our choices are best for our clients.

There are times when we will sell an investment that we have held for a while and introduce a new one within the same asset class. The behind-the-scenes research into these decisions is extensive and leads to spirited discussions in our weekly planners meetings.

Over the past few months, we have decided to replace a few long-held funds, so we thought it would be a good idea to share some of the factors that lead us to decide to replace a fund. Each decision is made under a unique set of conditions but here are some of the more common reasons that would motivate us to consider a change.

1. Change in Fund Manager – When a mutual fund manager steps down, we take immediate notice, since this could lead to a drastic shift in performance or investment approach. Of course, there are times when a manager change is not a major concern. Some funds are run by a team of managers with years of experience on the fund and the loss of any one of them may not be a reason to drop the fund. Some funds, however, are dominated by the decision making of one or two people. When a key person decides to step away, we will consider replacing the fund, especially if the new manager is new to the strategy or has not worked on the fund as a co-manager or analyst for a meaningful amount of time.

2. Change in Strategy – Style drift occurs when a mutual fund slowly changes how it invests over time so that its holdings no longer match its stated strategy. If a traditionally conservative fund has been underperforming, its managers may become more aggressive in order to improve returns. Recent examples of this have happened in bond funds. The Federal Reserve pushed down interest rates over the past decade to historically low levels, reducing bond yields. To become more attractive, some managers reached for yield by buying riskier debt to provide higher income. If we were holding a previously conservative bond fund that began to take on more risky debt, it would not be fulfilling the role we expected and we would consider making a move.

3. Failure to Perform as Expected – We invest in a variety of funds in different asset classes to take advantage of different market environments. We would expect our international funds to do well when international markets outperform the U.S. Similarly, we would expect large capitalization growth stock funds (think tech-heavy funds) to outperform value funds (e.g. energy and financial-heavy funds) when growth is in favor. If a fund describes itself one way and acts like another, we would look at the reasons behind that to avoid having duplicate strategies or uneven exposure to certain types of markets. It is important for our funds to be consistent and fulfill their role inside the portfolio.

4. Relative Performance – Somewhat related to expected performance, there are some funds that just haven’t kept up with their peers. There could be valid reasons for this in the short-term that would cause less concern. For example, some conservative funds we hold for risk-averse clients are designed to do better than its peers during market declines by losing less money. A major component of long-term returns is to lose less during market selloffs. If these funds lag during rising markets, that is to be expected. However, we look for those rare funds that have provided exceptional value over long periods of time covering different market conditions.

This is not an exhaustive list of why we would replace a fund but it does cover the most common reasons. There are cases where a fund is performing adequately, but we identify a newer fund that we expect to perform better for the long term and decide to make a change. All decisions go through a thorough research process before being presented to our investment committee and planners group for a healthy debate so that we can make the best choices for your investment portfolio.