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Saturday, 28 March 2009

Should You Forgive Your Fund?

By Michael Breen

The late John Templeton was a patient investor who kept his head while others lost theirs. He didn't let near-term events push him off course. When times were bleakest, he'd produce a chart showing all the bull and bear markets back through the Great Depression. FAM Funds recently gave me an updated version of that chart, and it still makes its point: Bear markets are followed by bull markets that tend to be longer in duration and greater in appreciation. But looking backward from deep inside a bear market, it can be hard to foresee better things for stocks.

Now is such a time. We've blown through the losses of the 1974 bear market and the tech-inspired downturn of the early 2000s. The S&P 500 Index has lost an average of 2.5% annually over the trailing 10 years--its worst run since the 1930s. Stocks have shown signs of life lately but have a long way to go before they crawl out of the hole they're in.

Mind the Midstream Changes
In such an environment, you need to fight human nature. People tend to overemphasize what's happened lately and adjust their behavior based on it. Sociologists call this recency bias. And it's a big reason there's been a stampede out of stocks and into cash over the past year. But you can't go back in time. Switching to cash now won't get you the protection you needed before the crash. Rather, it is a bet that cash will defy historical trends and outperform equities in the future. The longer your time horizon, the more unlikely that is. And research shows that a tiny percentage of trading days generate the bulk of the stock market's returns over time, so trying to time the changing tides is nearly impossible. Review your plan to avoid rash, ex-post facto allocation moves that could hamper your progress toward a long-term goal.

The same forces apply to fund picks. Many top equity-fund managers have posted huge losses in the current bear market, while others have lost less. But that doesn't mean you should conduct a wholesale swap of the former for the latter. Mistakes were made and piles of capital were destroyed. But be leery of trying to win the last war. Just as it's not wise to chase performance into hot funds after they've had a big run-up, moving into more-moderate funds near the bottom of a trough could limit your returns in a rebound. If you've underestimated your risk tolerance or your goals have changed, adjustments should be made. But if your long-term target remains unchanged, tread lightly.

A Short Checklist
Before ditching a fund, review its long-term record, the stability of its investment process and personnel, and the portfolio's prospects. If it passes muster on all three, you should think twice about ditching it.

Below we test a couple of funds that have taken heat lately and suffered outflows: Dodge & Cox Stock (NASDAQ:DODGX - News) and Oakmark Select (NASDAQ:OAKLX - News).

First, let's look at the funds' long-term record alone. This is a good sanity check because it helps limit the impact of recency bias. Below are the 10-year returns for some of our large-blend and large-value Fund Analyst Picks, funds we consider good core holdings.

To view the table, click here. http://news.morningstar.com/articlenet/article.aspx?id=285047

Looking at this data alone, Dodge & Cox Stock and Oakmark Select look like stalwarts. Everyone is struggling, but they've made more money for investors over the past decade than nearly all the other Analyst Picks, easily topping their category peers and benchmark indexes.

Adding near-term performance drastically changes the picture. Below the same funds are sorted by three-year returns. Dodge & Cox Stock and Oakmark Select fall to the bottom of the pack because they've made mistakes lately. So, looking at just near-term returns the funds appear poor. But the damage hasn't been fatal: Their long-term records remain better than the funds that have lost less in recent years, such as Sequoia (NASDAQ:SEQUX - News), Jensen (NASDAQ:JENSX - News), and Sound Shore (NASDAQ:SSHFX - News).

To view the table, click here. http://news.morningstar.com/articlenet/article.aspx?id=285047

This begs the next and most important question: Do the recent stumbles by Dodge & Cox Stock and Oakmark Select indicate a deteriorating investment process or staff? We don't think so. Big mistakes were made by both and we aren't diminishing those. Dodge & Cox Stock blew it on a number of financials picks, while Oakmark Select got hurt by a big bet on Washington Mutual. But we think those mistakes were isolated and lessons have been learned. The process and teams that built the funds' strong long-term records remain intact. We see nothing to indicate these funds have permanently lost their touch. And we think the long-term record is more indicative than its recent record of what a shop can do. As my colleague Karen Dolan points out in this Fund Spy, poor performance triggers a review of a fund's approach. But it takes weakness in the approach itself for us to change our opinion.

Finally, we check the fund's current portfolios for red flags. Nothing jumps out. Both are full of low-valuation stocks with solid cash flows and manageable debt levels. These are same type of stocks they've always owned and with which they built their strong long-term records. Oakmark Select remains concentrated in its top holdings, which brings risk. But, that has always been its formula and it has worked more often than not over time.

One Size Doesn't Fit All
There are fine funds of every stripe. The key is to pick one with a risk/reward profile that matches your tolerances. Warren Buffett has said he'd much rather earn a lumpy 15% a year over time than a smooth 12%. But not everyone can stomach that. The thing to guard against is making changes at inopportune times based solely on a fund's recent performance. Remember, changes made today are a bet on the future--not the recent past--and the former rarely looks like the latter.

Michael Breen does not own shares in any of the securities mentioned above.

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