I recently worked with a client that subscribed to the Jack Welch method of culling bottom performers in his portfolio. Each year he would fire the bottom 10% of mutual fund managers based on last year’s performance.
While on the surface this may seem like a rational strategy, it shows a lack of underlying investment philosophy and can result in getting rid of solid performers for the future.
By removing the bottom percentile of performers in any given year:
You remove the funds that provided counterbalance to those that won recently. Those winning strategies and categories may be the losers in the upcoming year, while the losers may turn out to be your saving grace.
You may be inadvertently employing a very unwise strategy of buying high and selling low.
You may be increasing allocations to areas of the market you did not intend. If you are investing in active managers you may over-allocate yourself to various areas your managers are gambling will outperform. Active managers who outperform often do so by overweighting investments outside of the category you hired them for. If too many of your managers outperformed due to similar guesses, by selling your losers to allocate to the winners you may be further overweighting areas you did not intend.
Consider the performance of the Fairholme Fund (FAIRX). After receiving the 2009 Morningstar MORN +1.09% Domestic Fund Manager of the Year award, followed by a 2010 finish as the top fund in the Large Value category, in 2011 the fund finished dead last.
If investors lost faith at this point they missed out on a 2012 rebound to the top spot in category, and a 2013 finish in the top 14%.
And it appears as if many investors and advisors did in fact mistime their investments with Fairholme. Morningstar’s reporting of Investor Returns over the past 3 year period are a -1.11% compared to the fund’s performance of 7.55% annual. Investors in this fund rank in 99th percentile for investor returns in the Large Value category.
Should you then stick with losers? Not all losers rebound like Fairholme has, nor is a good year or two indicative of the future.I recommend investment for the long-term based on a philosophical and portfolio match rather than investing based on performance over a year.