‘Watch List’ Lets You Build Case Against Underachiever

Deciding whether a mutual fund is worth holding on to is like solving a jigsaw puzzle: You can’t get a clear picture until the pieces come together. That’s where your “watch list” comes in.

Investors should always pay attention to their funds, but funds on your watch list require heightened awareness. It’s a “yellow alert” status on a defensive scale, whereby increased danger will trigger the “red alert” and a sale.

“Your watch list is where you build a case against a fund,” says Roy Weitz, publisher of Fund Alarm (https://www.fundalarm.com), a Web site that alerts investors to funds that are ailing. “It’s like examining evidence. A piece or two might not mean anything, but put enough together and you have a case for selling.”

Once the caution flag goes up, look for telltale changes that connect the puzzle pieces. Funds can get off the watch list quickly--as warning signs either pass or create a desire to sell--or can stay in the handle-with-care mode indefinitely.

Put a fund on your watch list whenever:

* Performance starts to lag. Everything that affects a fund eventually hits the bottom line, so lackluster returns light the proceed-with-caution sign.

Compare a fund to both its peers and its own history. Volatility is a way of life for some funds; if your fund has a history of good returns with occasional lapses, it is less worrisome than a once-steady winner that falls behind.

“If performance rebounds, you stop worrying and don’t sell,” says Janet Brown, editor of the No-Load Fund*X newsletter. “If performance gets worse, you drop the fund.”

Experts disagree about how long to stick with an ailing fund. Give a proven performer at least six months--and maybe up to two years--to regain its touch.

* The manager leaves. Management departures alone are not a signal to sell, so long as the new skipper steers the ship with a steady hand.

“Check into what is going on, why the manager left and how the replacement will handle things,” says G. Edward Noonan of Triad Investment Advisory in Hingham, Mass. “Then watch performance, looking for an evolution in how the fund operates. Once you know the change hasn’t damaged the fund, take it off your list.”

* The fund company gets taken over. New leaders can change how a fund is run, tying a manager’s hands, changing the research available and more. Besides, takeovers tend to spur manager departures. If the old manager can’t work in the new environment, you may not want your money there, either.

* Assets surge. Bigger funds buy bigger stocks. That’s a problem if you want a fund that buys small or mid-sized stocks. Any time a small-company fund crosses the $1-billion mark, it is likely to drift toward medium-sized companies. Mid-cap funds drift toward giant stocks between $2 billion and $3 billion.

If a fund is getting big, watch its portfolio carefully to see if it continues to do the job you bought it for.

* The fund closes to new investors. This is supposed to protect investors by keeping a fund true to its investment objective. But it sometimes happens too late, after the fund has passed its optimum size. Cutting off new investors won’t make the fund small and nimble again.

In addition, the lack of new cash sometimes inhibits a manager, forcing the sale of securities to meet redemptions.

Says Thurman Smith of Equity Fund Research in Malden, Mass.: “If a fund closes and you see deterioration in performance, you have a partial explanation that makes it easier to say goodbye.”

* Portfolio characteristics change. Whenever a fund does something out of character--say, boosting expense ratios or marketing fees or doubling its turnover rate--proceed with caution.

If this is an anomalous event--a year’s time should tell you--drop the yellow flag. But if this warning sign shows up with other signals--most notably poor performance--the pieces of the puzzle are creating a picture.

* You receive a proxy statement seeking to change the fund. A fund needs your permission to change its objective, the types of securities it buys and more. A proxy vote automatically fires up the warning lamp.

In most cases, the changes will be nothing to fear. Still, says Weitz, “if an under-performing fund is asking to widen its investment scope, it’s a sign that the manager feels boxed in and is squirming and looking for a way out. If that happens, you may want to start looking for a way out too.”

* Your objectives change. Much of your satisfaction with a fund comes from your own needs and comfort levels. The same fund that has been appropriate for you during the last 10 years may not be a good fit in the future.

If your focal point is changing, make sure your funds fit in with your new agenda.