Unload Losing Funds Now

Here's a New Year's resolution you can keep: Sell your lousy funds. Better still, sell them now -- and start 2007 with a clean slate.

We all know how difficult it is to pick funds that will beat the major stock indexes. Indeed, most people will do better not trying. Instead, keep your life simple and invest in low-cost index funds. Put 75% of your stock money in Vanguard Total Stock Market Index (symbol VTSMX) or Fidelity Spartan U.S. Equity Index (FUSEX) and the other 25% in Vanguard Total International Stock Index (VGTSX) or Fidelity Spartan International Index (FSIIX) -- and stick with the plan. Over the long haul, you'll beat more than two-thirds of actively managed funds.

But if you want to try to beat the indexes, give yourself a fighting chance. How? Don't hang onto losers.

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Almost all of us hate to sell a fund that has lost money. Academic studies have found that investors often tend to sell their winners for small profits and hold onto their loser -- -until they break even. That's precisely the opposite of what you need to do to beat the benchmarks.

The saddest story I heard all year involved the Markman Core Growth fund. Manager Bob Markman's fund plunged 59% during the 2000-02 bear market but has rebounded since. The sad part: As the fund has risen in price, investors have cashed in their chips. It's a case of waiting to get even to sell.

Please don't do that with losing funds that you own. Instead, sell now. One of the most expensive notions among investors is the idea that you haven't lost money in an investment until you actually sell it. The truth is that you've already lost the money -- you just haven't taken your medicine yet. And every day that you wait is a day you could be in a more promising investment.

The academics term this phenomenon "loss aversion." Their studies have found that people hate to lose money more than they like making money. Many investors are so loss averse that they'll hang onto losers rather than sell -- and avoid taking reasonable risks to earn big profits.

Don't get me wrong. I'm not trying to encourage you to hop from fund to fund. If you've found a first-class fund, you should stick with it so long as the same manager is still running things, the fund hasn't become bloated with assets and the fund's performance hasn't been wretched for several years compared with funds that invest in the same kind of securities. Even the best fund managers suffer a bad year or two.

But if you made a mistake in buying a fund in the first place, you should sell as soon as you realize you erred. The question you should always ask yourself before not selling a fund is simple: Would I buy this fund today if I didn't already own it?

A lot of people cite taxes as a reason to hold onto crummy funds. But by holding on to a fund with an unrealized capital gain all you do is delay when you pay taxes. Eventually, you have to pay. And what you might save by holding on is tiny; you'll more than make up for it in a better fund.

Another objection to selling I hear often is this: "As soon as I sell the fund, it'll go up." Maybe so, but you have to use your common sense in picking funds, not your superstitions. Otherwise, see paragraph two: stick to index funds.

There are lots of lousy funds out there -- a lot more than there are good ones. Otherwise, two-thirds of funds wouldn't lag the index funds.

Look at a fund's fees

Let's start with the easy stuff. Sell funds with egregiously high expense ratios. On average, no-load stock funds charge about 1% a year for expenses. The higher a fund's expense ratio the less chance it has of beating its benchmark. Yet Standard Poor's database lists 2,617 funds -- or well over 10% of funds -- with expenses in excess of 2% annually. That includes load funds from such shops as UBS, Putnam, ING, Franklin, Federated, Eaton Vance, Black Rock, AIM and Dreyfus. It includes a hefty number of no-load funds and even some bond funds.

How much should you pay for a fund? As little as possible. That's why Vanguard is often a good place to start hunting for a fund, and T. Rowe Price often ranks number two. These shops generally have low expenses and offer good performance. Fidelity's fund performance has been uneven in recent years, but its expenses are low.

There are exceptions to the fee rule. Bill Miller's Legg Mason Opportunity (LMOPX) is a superb fund despite charging 2.08% annually. But Miller is as close as there is to a fund superstar, notwithstanding the disappointing '06 performance of his other fund, Legg Mason Value (LMVTX).

Be wary of tech-bubble losers

Another great place to look for sell candidates is among funds that belly flopped during the 2000-02 bear market. Lots of us made the mistake of piling into tech-laden funds in the late 1990s and failing to sell before the implosion. But what's the reason for holding on now?

The SP 500 plunged almost 50% during the disastrous bear market, and the Russell 1000 Growth index lost 61%. I'd sell almost any fund that did much worse than the Russell index. Many of the biggest bear-market losers no longer exist, having been liquidated or merged into other funds. But some are still around and taking money from investors. The Van Wagoner funds, Jacobs Internet, the Firsthand funds are all funds I'd dump. Indeed, I'd deep-six every tech sector fund. Let your diversified fund managers decide how much to invest in technology.

Most if not all of the Janus funds collapsed during the bear market. Of course, that was before the firm got caught in the rapid-trading scandal. Still, many investors maintain their holdings in the Janus funds. About $11.5 billion is invested in Janus Fund, and $10 billion is in Janus Twenty. I don't expect another bear market like the 2000-02 one anytime soon, but Janus lost 60% during that bear market, while Twenty lost 67%. Sell.

While we're on fund companies that once were good but have lost their touch, you might want to take a careful look at any Dreyfus or Putnam funds you own. Most of these should be sold, too. Ditto for AIM funds.

Asset bloat is another reason to sell. The folks at Cohen Steers know real estate investment trusts, but they're managing too much money in a fairly narrow sector of the market (senior editor Jeffrey Kosnett thinks highly, though, of CS's foray into Asian property stocks; see Investing in Foreign Real Estate Goes Mainstream). Similarly, the Royce funds are good at ferreting out stocks of small companies, but they, too, hold too much money.

Next, sell any gimmick funds you own. These include long-short funds and bear market funds. If you want to cushion against a market decline, put more money in a bond fund or in cash.

Selling your bad funds won't guarantee that you'll beat the market. But it's a good start. Happy New Year!

Steven T. Goldberg is an investment adviser and freelance writer.