Not too long ago, a well-known mutual fund manager got into a tiff with a well-known hedge fund manager over a well-known company’s stock. The hedge fund manager thought the company had deeper problems than it was admitting to publicly and bet the stock would drop. The mutual fund manager, believing the company was undervalued, bought up nearly a third of the outstanding stock (he also became the company’s chairman).
Pop quiz: Is this a mutual fund you want to own?
Need more info to help you decide? Assume both managers had outstanding long-term track records, but the debate over this one company may have become a distraction. Since getting involved with this holding, the mutual fund manager’s performance has suffered.
Do you hold onto his fund or cut it loose?
You probably have no idea what to do; I’m sorry, it’s a trick question. That’s probably because you’ve never considered the criteria for leaving any mutual fund. Most investors think long and hard about why they buy this fund or that — but they never think about when or why to sell.
This question involves huge sums of money. Ninety million individuals in the United States have $12 trillion invested in mutual funds. In terms of saving for retirement, mutual funds holdings account for 54 percent of 401(k)s and 47 percent of IRAs (in dollar terms). The 8,500 “Registered Investment Companies,” as these mutual funds are formally called, hold 27 percent of all outstanding stock of public companies in the United States.
Hence, most of your invested dollars in 401(k)s and IRAs are probably handled by a mutual fund manager. We shall leave the important question of active vs. passive investing — ETFs vs. mutual funds — for another column. (ETFs hold far less money, with less than a trillion dollars in assets).
Which brings us back to our rather interesting and oft overlooked question: When do you fire your fund manager?
When you buy a mutual fund, you are essentially hiring a manager to handle your assets. Typical investors research various fund families, use Morningstar to review history, review the fund’s top holdings, consider long-term track records. They do all of this work to answer the question, “Which fund should I buy?” But in my experience, they hardly ever consider the other side of that equation.
Most buyers of mutual funds are doing so for a variety of reasons: They want exposure to a given asset class, such as technology or small caps. They may be looking for professional assistance in stock selection. Perhaps they want to participate in a given region but lack the boots on the ground to make intelligent buys.
While there are many reasons to hire a fund manager, there are just as many reasons to fire one. Here are my main criteria:
When they suffer from style drift: This happens quite often; a manager developed an expertise in a given area but is looking beyond that. Maybe they got bored. Maybe the new cow in the pasture caught the bull’s eye. Whatever it is, they are doing less and less of why you bought them in the first place. That’s your signal that it’s time to move on.
When they become too big: Some managers find a niche that they can profitably exploit. But beyond a certain size — which can range from less than $1 billion to about $5 billion — they no longer can create alpha with that strategy. This may be true for eclectic segments such as convertible arbitrage, but I have found it is especially true for small cap and technologies, and emerging markets.
When they fight the dominant market trend: Bill Miller’s market-beating 15-year streak came to an end amid a value trap. He bought more and more of his favorite holdings — banks, GSEs and investment houses — right into the financial collapse. Doubling down again (and again) is not a valid investment strategy. Whatever advantages he had heading into 2008 disappeared.
When they seem to lose their edge: Whether it’s success or money or a loss of interest, managers sometimes lose the “fire in the belly.” Determining this is admittedly challenging. We often find out about some personal demons — divorce, alcohol, whatever — after the fact. Regardless, when whatever it was that made them a top stock picker starts to fade away, you should also.
When they become a closet indexer: When a fund owns 100, 150, 200 names, it effectively becomes a high-cost index. Even if they have the top performing stocks, it will be in such small quantities as to not move the needle. This is an easy fix — you replace them with a low-cost, passive index.
Notice that performance is not a factor in any of the points above. There are two reasons for that:
Process, not outcome: Investors ought to be focused on creating a reproducible methodology, regardless of luck or misfortune in any given quarter. Investing is a probabilistic exercise, and performance can slip for a quarter or two — even when the manager is doing everything right.
Mean reversion: The opposite of chasing performance (and buying high) is dumping a weak quarter (selling low) that then snaps back.
With that, you have the signals to know when it’s time to take your money and go.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He runs a finance blog, The Big Picture.