The decision to sell an underperforming mutual fund can be a difficult one -- a lesson learned the hard way by millions of investors over the last decade of extreme financial market volatility. A well-timed allocation change can improve returns or reduce risk of loss, but requires keen judgment and rare foresight. More often, investors exercise a "rear view mirror" approach, selling funds at precisely the wrong time, leading to higher taxes, transaction costs and risk of further underperformance. Here are some questions that need to be answered before proceeding with a change.

By what measure?

Before a fund can be characterized as underperforming, we need a yardstick, or benchmark, for comparison purposes.

		Donald Belt is chief investment officer and Brian Koble is research analyst for Hefren-Tillotson Inc., a Downtown-based investment firm.

The first rule when choosing a benchmark is that it be appropriate. Large cap equity funds should be compared to a large cap equity index such as the S&P 500, or to a peer group of funds that invest according to a similar objective. Inappropriate benchmarks can make good managers look bad, and bad managers look compelling. Ideally, benchmarks should be specified prior to a fund's purchase, thereby reducing the temptation to "lower the bar" at a later date in order to make a poor decision appear wise.

How long and how much?

One of the most difficult questions to answer in this process concerns how long underperformance should be tolerated. Investors often hold on to underperforming managers for far too long, frequently due to an emotional attachment to the investment. Other investors are too quick to pull the trigger on underperforming managers in cases when the performance slowdown is only temporary.

The duration and degree of underperformance that is acceptable depends on the investment style of the manager. There is very little margin of error for index or enhanced-index investments. On the other hand, active mutual funds that take large sector or security bets typically deserve a longer leash, perhaps as long as several years. Just as value and growth stocks will assume leadership at different moments, mutual fund managers also will fluctuate between periods of outperformance and underperformance relative to their peers. World class investment managers will adhere to their discipline even when it is out of synch with the market. Over time, market leadership invariably rotates, and the manager's style once again gains favor.

Bottom line: provided that a manager has a world class team, a strong long-term track record, and a disciplined investment approach, investors should exercise patience.

What went wrong?

When underperformance becomes protracted, investors should seek to understand the nature of the problem. If it is due to a fundamental change at the fund, a sale could be in order. If the underperformance is due to more transitory factors such as a handful of isolated poor investments, it should be addressed on a case by case basis.

Fundamental factors are those characteristics that are essential to a fund's long-term success, commonly known as the "3 P's": People, Process, and Portfolio Construction.

People: Turnover among a fund's key decision makers is a common and in many cases justified reason to liquidate a position.

Process: The process by which a manager identifies and selects investments is critical to a fund's success. A significant change in approach introduces considerable uncertainty regarding the likelihood of future out-performance.

Portfolio Construction: Managers should always invest according to their stated objectives and prospectus requirements. Investors also should be wary of "style drift," which occurs when managers invest outside their areas of expertise to take advantage of a red-hot area of the market. In doing so, the manager takes risks that the investor did not expect in purchasing the fund. Also, asset growth can alter a portfolio's construction, forcing the manager to own more positions and creating difficulty in entering and exiting positions.

What about risk?

Viewing returns apart from risk can be very misleading. A fund may achieve high returns, but do so by taking on considerable risks that increase the potential for loss. Accordingly, a sale may be warranted even if poor performance is absent. Conversely, a manager may trail its benchmark modestly, but exhibit a low risk profile. Experience tells us to be cautious when encountering the first type of manager, but be forgiving of the latter type.

Other factors

Other important factors to consider include increases in expenses or fees, changes to the fund's board or ownership structure, and tax sensitivity. It has been our experience that if the original factors that led to the hiring of a manager remain in place, such as low expenses and world-class management, then investors generally should be patient in enduring short-term periods of underperformance. On the other hand, if the fund was purchased for the wrong reasons or if there are significant changes to essential fund characteristics, investors should seriously consider altering their portfolio allocation.