Falling funds: when should investors cut their losses?

Practical pointers on how to decide whether to sell, hold or buy more of a fund or trust that is not delivering.

It is never easy to call time on an investment that has disappointed. Selling at a loss effectively means admitting defeat – and this is something that all investors struggle with because, as humans, we feel the pain of a loss more acutely than the pleasure of a gain.

“It is easy to understand why buying is a more enjoyable stock market experience, unless you are selling to bank a large profit,” explains John Husselbee, head of multi-asset at Liontrust Asset Management.

Nevertheless, there is still much to be said for having a clear sell discipline in place, whether it is at a profit or a loss. Drawing a line under an investment that has gone wrong will allow you to move on and hopefully to allocate money to an alternative fund or investment trust with better prospects.

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However, there is always the risk that you get the timing of your sale wrong. Some nervous investors will have learned this the hard way in March last year: as markets tumbled, they panicked and sold out at what turned out to be the bottom, missing out on the dramatic recovery that followed.

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So if you are holding a fund or investment trust that has disappointed, how can you decide whether to sell out or hold on in the hope that performance improves?

The starting point is to consider why you invested in the fund or trust in the first place, and whether it is fulfilling the role you intended.

“A classic example would be if you bought an investment trust for income and it is no longer delivering, then you should move on to something else,” explains Andrew Lister, head of closed-end fund strategies at Abrdn.

Understanding performance

The next step is to consider why the fund has disappointed. How does performance compare to the index or peers? For example, if the fund has outperformed peers in spite of challenging market conditions and you are still comfortable gaining exposure to the underlying market, this could be a sign to hold on.

Lister never sells out of an investment trust purely based on performance. He says it is important to look beyond the headline numbers to get a handle on why the fund has disappointed. “Our number one reason for selling is usually because we can’t understand why it is doing badly,” he adds.

As an investor, you can stay on top of a manager’s latest positioning by reading the fund’s monthly factsheets, as well as ad hoc commentaries and videos. Meanwhile, investment trust investors have access to annual and half-year reports, which should shed light on the fund manager’s thinking.

Lister notes that it is important to consider whether the fund manager’s latest commentary provides context for performance. From the fund manager’s perspective, he says “it is always better to be candid than to window dress”.

He highlights Nick Train as a good example of a fund manager who has been open and honest with Finsbury Growth & Income (LSE:FGT) trust’s investors about why the portfolio has underperformed in recent times, particularly in light of a number of stock-specific issues.

David Lewis, co-head of strategy for Jupiter’s multi-manager Merlin fund range, agrees that context is crucial when it comes to understanding why a fund has disappointed. “Is it a number of stocks that has driven the poor performance or has the manager systemically got a bias to a certain area that has been out of favour?” he asks.

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Lewis adds that it is important to consider how the fund manager has responded to these challenges. For example, have they added to a stock that has gone wrong or opted to sell out?

“We are generally buying into managers who are stock pickers, who are aware of their sector positioning but are not beholden to it. They can have significant biases and that can lead to out or underperformance at different times.

“What we are less willing to accept are managers who are making poor judgement calls on stocks because we are trying to fundamentally buy people who are good at picking companies. If they are making lots of stock-specific errors, that is a very challenging thing for us to live with,” he explains.

This is why Lewis and his team look for managers with a strong sell discipline.

“A degree of investment is luck and judgement, so you have got to be aware that managers will have individual situations go wrong. But you also want to see people with a strong sell discipline within their process, so that when things go wrong with an underlying stock, they have a strategy to deal with it,” he says.

Consistency is key

Lewis suggests looking for other hints that might explain why performance has disappointed. For example, if the fund manager appears to be changing their style to accommodate larger sums of money under management or to adapt to market conditions. This is known as ‘style drift’ and can present a red flag for investors.

“We struggle with fund managers who lack an ingrained process or don’t stick to their process,” he adds.

Liontrust’s Husselbee agrees: “Consistency of performance is impossible, but consistency of process should be a prerequisite for investors and can ultimately lead to long-term excess returns.”

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Husselbee typically buys fund managers because they follow a certain investment style and therefore wants to see the manager sticking to their approach, whatever the backdrop.

“Baked into that is the understanding that managers with a strong style bias can go through lengthy periods of underperformance.” 

For example, growth stocks outperformed their value peers for the best part of a decade up to the vaccine announcements last November. During this period, economies looked sluggish and investors were prepared to pay almost any price for the prospect of growth. However, since last November, value stocks (which tend to be more sensitive to economic cycles) have performed well during a period of economic recovery.

Go back to the start

Husselbee adds that one way to cope with periods of underperformance is to set realistic expectations at the outset.

Lewis suggests going back to the starting point: if you were looking at the fund or investment trust with fresh eyes, would you buy it for your portfolio today?

“People have an ingrained dislike of crystallising losses, but the key point is to try to step back from those psychological heuristics and say, with a blank sheet of paper, is this the type of investment I would buy? Is it attractively valued now?

“Just because a fund or stock has fallen does not mean it is bad, it just means it is priced lower than before. Potentially it is priced more attractively than when you invested in the first place,” he explains.

Lister agrees: “You want to avoid selling out at the point of maximum pessimism because you could then be kicking yourself for years to come that you sold at the very bottom.”

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This brings an important question to the fore: if you still have conviction in the fund manager and their underlying holdings look attractively valued, should you consider buying more? This is particularly relevant for investment trusts, which can swing to wide discounts to net asset value (NAV), presenting an attractive entry point.

Lister explains: “We are buyers of investment trusts with good long-term track records that are suffering a short-term setback because of a shift in sentiment, style or leadership. If you hold one of those funds and it has gone to a discount to NAV but you believe the long-term story, then quite often those are good buying points.”

Finally, if you decide to sell out of a disappointing investment, what would you hold in your portfolio as an alternative?

Lewis says there is nothing wrong with selling out if you have more conviction in another idea, but advises investors not to lose sight of valuation.

“There is always competition for capital, so there is not necessarily anything wrong with selling something at a discount if you are increasing the calibre of the portfolio you have got. You just have to be aware that selling out of things that have gone down and buying into things that have done well is generally a fast way of losing money,” he concludes.