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The No-Load Fund Investor The No-Load Fund Investor

Education

How to Build a Profitable Mutual Fund Portfolio

When Is the Right Time to Sell a No-Load Fund?


How to Build a Profitable
Mutual Fund Portfolio

If you agree that mutual funds offer opportunities for profit and safety, where and how should you allocate your assets? First, it's a good idea to own several funds. For investors with a $100,000 portfolio whose primary goal is growth, we recommend as many as nine funds diversified in various segments of the market. Owning more than one no-load doesn't cost any more. When your funds are properly selected, you gain the benefits of diversification and management expertise, with significantly less risk.

Know what you own.

If you currently own funds, begin by grouping them according to their objectives. For this task, a pad and pencil are all you need. Lists the riskiest funds in the aggressive equities section, growth-income funds in the conservative equities section, bond funds (corporate or municipal) in the fixed-income category, and money market funds in a section of their own.

The categories are not hard and fast. For example, if you are primarily interested in income, and have that orientation in your portfolio, you may want to put growth-income and income funds, which contain high-dividend stocks, in the income category. Growth funds could be placed in the aggressive growth category.

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The financial pyramid.

Once you know exactly what you own, you should evaluate your portfolio, and make changes whenever necessary to ensure that your assets conform to your objectives. For example, even if your primary goal is aggressive growth, that doesn't mean that all your assets belong in aggressive growth funds. You should have the majority of your assets in more conservative investments and even a bit in cash so that your portfolio will never suffer catastrophic losses. Similarly, even if your objective is current income, don't put everything into fixed-income funds. Some of your money should be in income-producing stock funds to provide protection against inflation.

Lower-risk investors should apply the principle of the financial pyramid. (See above.) First, put the largest part of your assets in safe investments that provide a decent return. Next, invest in securities that provide for long-term growth of capital. Then put a smaller portion of your capital in more speculative vehicles. A small amount can go into high-risk vehicles that promise a high return if successful--but could result in a substantial loss.

24 model fund portfolios.

We divide investment objectives into categories oriented to the investor's lifestyle goals, ranging from growth to income/capital preservation. Then The No-Load Fund Investor provides sample fund portfolios for each category. Each portfolio contains between seven and 10 funds. None of the portfolios are speculative or high-risk.

Here are the four lifestyle orientations that guide the selection of funds:

  • The Wealth Builder approach is designed for working investors whose goal is capital accumulation. This is our riskiest core approach, though even here we may stress low-risk funds. Current income is not a factor in this portfolio, so bond funds are often excluded. This portfolio has achieved outstanding results while investing conservatively.
  • The Pre-Retirement strategy is more conservative. Designed for investors who are within 15 years of retirement, it generally avoids big positions in the aggressive growth funds that can suffer the greatest short-term losses. This portfolio normally invests in fixed-income, equity income, growth-income, and lower volatility growth funds.
  • The Retirement orientation emphasizes income, capital preservation, and moderate growth. A portion of the portfolio is generally invested in equity income and growth-income funds as an inflation hedge.
  • The Income and Capital Preservation strategy is for investors in their mid-70s or older (or who are otherwise very financially conservative) who want a dual primary objective of income and capital preservation, with a secondary objective of modest capital growth to keep ahead of inflation.

A word of explanation is necessary here. Our four "Master Portfolios" contain our top recommendations drawn from all funds and fund families. These recommendations are replicated in 20 additional portfolios, which invest via single fund families and "no-transaction-fee" brokerage programs. (See our Model Portfolios page.) That's a total of 24 portfolios you may choose from, depending on your goals and preferred source for transactions.

Remember: these are only models. They can be followed to the letter, but each investor can make adjustments for his or her own risk preferences and lifestyle. With no-load mutual funds and ETFs, you can build a portfolio that's profitable and safe--to achieve wealth and guarantee your financial security. Our goal is to keep you in the best-performing funds and ETFs, in both good times and bad.

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When Is the Right Time
to Sell a No-Load Fund

One of the most frequently asked questions we hear, from both the press and individuals, is when to sell. The questioners almost always want a simplistic answer. The question is usually phrased as "How many months of underperformance before I sell? Six months, twelve months? Tell me exactly."

Weíre sorry, but itís just not that simple, and there is no reliable rule of thumb. In order to know when to sell, you need to know the reasons for disappointing performance. Basically they fall into three categories.

Three Types of Poor Performance

Market confidence. If you think the overall market is going down, this may be a reason to sell. Down markets obviously create poor performance. In this case the number of months of sub-par performance is irrelevant. If you decide to liquidate part of your equity holdings due to lack of market confidence, you would most likely sell the most volatile positions, because they would typically decline the most in any downturn. Most of our selling down in Best Buy portfolios during 2000 was because of weakening market conditions.

Changes in market leadership. This is the most common reason for underperformance in a given asset class or sector. It is, unfortunately, commonplace for investors to buy toward the end of a cycle of leadership. For example, if growth funds outperform value funds for two to three years, most investors will then shovel money into growth funds. Almost invariably, that is when the cycle ends. Value becomes ascendant, and the new growth fund holders find their funds lagging. Leadership can shift from value to growth, as in the early to mid 90s, or from growth to value, as in 2000. Similarly, small cap and large cap funds rotate leadership. Sector leadership also shifts, as we saw with technologyís rise and fall. This type of underperformance can be identified by checking performance of a fundís peers in the same category. If the whole category is down, an adverse change in market leadership is the cause.

What are the rules for selling when leadership changes? Thatís a tough one. The cycles between growth and value and large and small caps are erratic and extremely difficult to forecast. Also, keep in mind that these cycles donít mean fund managers are making bad decisions. Brian Rogers, a classic value manager, had several years of underperformance in the late 90s, when growth led. This didnít mean Rogers had lost his ability to pick stocks. He was simply staying true to his discipline. When the growth bubble was pricked in 2000, Rogers returned to above-average performance, and T. Rowe Price Equity Income has ranked highly now for years.

Our recommendation is to adopt a policy of modestly over or under weighting asset classes or sectors as leadership shifts. For example, if value is leading, we might allocate around 60% to value and the remaining 40% to growth. If growth then pulls ahead, we might reverse the percentagesó60% to growth, 40% to value.

One problem that can be related to leadership changes is called "style drift." This happens most commonly when small cap stocks are out of favor, and some small-cap managers slide up to mid-cap stocks. In theory, this shouldnít result in poor performance. But it can if leadership reverts to the fundís original mandate and the manager is slow to fall back in step.

Individual fund problems. Sometimes a fundís performance falters while other similar funds are doing well. While there could be many reasons, most fall into three categories: 1) The manager has changed; 2) the fund has grown too large; or 3) the manager has lost his or her "touch."

A manager responsible for strong performance in a prior period may have left the fund. Or, if still with the fund, he may have become too rich, tired, inattentive or unlucky to remain successful. Some fund managers run into a string of bad buys, just like baseball players fall into hitting slumps. We donít want to name names here, but there are a few iconic managers from the 80s and 90s and 2000s whose funds arenít world-beaters anymore. In some cases, these managers have grown fabulously rich after selling their management companies to large fund complexes. No longer do they put in the hours needed to excel in the stock-picking business. There was a case years ago of a fund that had been number one in America for several years, and then collapsed to near last place for another several years. After making discrete inquiries, we came to the conclusion that a major reason for the fundís declines was the manager had four girlfriends in four cities. He had been distracted from his principal task.

Growth in assets can become a problem, particularly for small-cap funds. However, itís hard to tell when a fund gets too large. Small-cap funds have closed with less than $150 million in assets, while others have done reasonably well with far greater amounts.

Good Reasons to Sell

There are circumstances that require an immediate fund sale, such as suspicion of fraud or a sharp decline in the fundís NAV due to revaluation of portfolio holdings.

Selling funds that are in net redemptions, for whatever reason, is almost always a good idea. It is harder to manage these funds, and when they sell off stocks to meet redemptions, larger capital gains distributions may follow. Exceptions might be a quarter in which a large capital gains distribution is made or modest redemptions because of a bear market.

In cases where the problem is with the individual fund, it is wise to allow the fund a set number of months of underperformance. If the fundís underperformance exceeds perhaps six months to a year, sell.

Selling for non-performance reasons. The article basically discusses selling because of poor performance. You, of course, may find non-performance reasons to sell, such as a need for more liquidity or money to fund a large purchase. This is a very different situation and can be done at any time.

Selling funds you never should have bought in the first place. Examples: high expense funds including 12b-1 funds, inappropriate funds that are either too aggressive or too conservative, and certain sector funds that donít meet your objectives. These funds can be sold immediately, and the money reallocated to more appropriate funds.

In sum, there are a number of times when you should sell. In only one caseóproblems at the individual fund levelóis the months of underperformance relevant.

How We Make Sell Decisions in Best Buys

If a fund in Best Buys is doing at least average, we will not delete it simply because another fund may be doing somewhat better over the short term. Ultimately, longer holding periods mean better after-tax returns. If a fund is deleted for performance reasons, its replacement will be one of its peers. However, if it is dropped for reallocation reasons, another type of fund will replace it.

Because of these practices, it is quite possible a fund can be dropped from Best Buys and yet retain its boldface listing in the tables. Occasionally, the reverse is true in the single-family portfolios. This happens when we need a fund for diversification purposes, but see no ideal choices available in a particular family.

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