'When should I dump an underperforming fund?'

@Money June 22, 2012: 2:22 PM ET

(MONEY Magazine) -- I'm trying to show patience, but after several years of subpar returns from a fund in my retirement account, I'm wondering whether I should I just pull the plug. How do you know when to sell an underperforming fund? -- J.G., Wallingford, Pa.

British punk rock band, The Clash, summed up your dilemma pretty well in its hit single "Should I Stay or Should I Go?." Plagued with indecision, the singer fears troubles lie ahead no matter which decision he makes.

In your case, if you stay you risk seeing your retirement dough languish even longer in a lagging fund. Go, and you might exit just as the fund is mounting a comeback -- or end up in a worse fund.

As much as I wish I could, neither I -- nor anyone else, for that matter -- can give you a set of rules for making the right move. This is a situation where you've got to assess each case individually and apply your best judgment.

What I can do, however, is suggest six questions to ask yourself that can help you come to a more informed decision about whether to sell or hold on.

1. Are you comparing apples to apples? Some investors assume they've got a dog on their hands just because a fund gains less than other funds they've heard about. But lower returns aren't necessarily an indication of lousy performance.

Before you even think of selling, you want to make sure the fund is actually lagging. The key test: How does the fund stack up against funds with a similar investing strategy? If you're worried about the performance of a large-company value fund, be sure to compare its returns against those of other funds that invest in shares of large undervalued companies.

You can do that by plugging the fund's name or ticker symbol into the Search box at Morningstar.com. Click on the Chart tab of the page that comes up and then choose the Benchmark pulldown menu. You'll get a graph that shows whether your fund's returns have lagged compared with those of other funds in the same Morningstar category and, if so, by how much it's trailed.

2. Is the performance gap significant? You don't want to jettison a fund just because it's not sitting at the top of the performance charts.

Occasional ups and downs are normal. So what's a big enough performance gap to pull the trigger? There's no official guideline, but I'd be reluctant to dump a fund as long as it remained in the top half of its peer group.

If you click on the Performance tab on any fund's Morningstar page, you can see whether it ranked in the top, second, third or bottom quartile versus comparable funds over a variety of time periods.

3. Is the fund consistent? Ideally, a fund should play a well-defined role in your portfolio, providing exposure to stocks of a particular size or bonds of a certain quality and maturity. But managers sometimes try to juice their returns by pushing the envelope. The manager of a domestic large-cap fund may bet on mid- or small-caps if he thinks they're poised for a big run, or even make a foray into foreign shares.

But such moves can backfire, not to mention make it more difficult for you to know how your overall retirement account is actually invested. The more likely a fund is to shift its investment style, the more apprehensive you should be about keeping it.

By choosing Morningstar's Portfolio tab, you can get plenty of details on its current investing style and see whether that style has varied over the past five or so years.

4. Are you overpaying? Higher expenses don't guarantee that a fund will trail its peers, but it makes it pretty likely. Plus, the fatter a fund's fees, the more risk it must take to compensate for the drag of higher expenses. And the more aggressively it invests to try to stay competitive with lower-cost funds, the harder it's likely to get hit any time the market turns against it.

If your fund is underperforming and has fees that are significantly above the average for its peers, I'd say that's a powerful argument for looking for a low-cost replacement.

To see how your fund's expense ratio compares to that of comparable funds, just plug its ticker symbol into CNNMoney's Search box at the top of this page and scroll down to the Peer Comparison section.

5. Would selling cause a tax headache? If the fund is in a 401(k), IRA or other tax-advantaged account, taxes aren't an issue. But if it's in a taxable account and you've owned it long enough that you have sizeable gains (despite its recent problems), selling could generate an income tax bill.

You certainly don't want to hold off selling a true turkey because you fear the tax bill. But you may want to take the tax effect into account in deciding how to get out. For example, you might consider splitting the sale between two tax years to avoid a big hit in one year. Or you might want to wait until you go through your annual rebalancing routine to see if you might shave your tax bill by pairing gains (or losses) in the fund you're planning on unloading with losses (or gains) in a fund you're planning to hold.

6. How long has this been going on? With up-to-the-minute performance data available these days, many investors feel they should pull the trigger at the first sign that something's awry. But that can be a mistake.

Many funds go through occasional rough patches only to later right themselves. If you bail at the first sign of subpar performance, you could find yourself making lots of unnecessary switches.

There's no consensus on what the grace period should be for poor performance. But generally I'd give a trailing fund the benefit of the doubt for a year or so, but not more than two years. If a fund manager can't turn the fund around within that window, it's probably time to move on to a fund with a more credible track record.

One more thing: The problem you're grappling with is unique to actively managed funds, or funds that rely on the manager's skill to outperform their peers and market benchmarks. You can easily get around this issue by sticking to index funds, which are designed to track a specific benchmark rather than beat it.

Investing in index funds won't assure you'll earn the highest returns (although over long periods such funds do typically outperform most actively managed funds). But if an index fund falters, at least you'll know that it was because the market or index it tracks went down, not because the manager screwed up.

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