When Good Funds Go Bad

Apr 11, 2016

We all know what to do when good pets go bad – make a bad reality TV series! But what should an investor do when a good mutual fund “goes bad?” Emotions tend to run strong and there is an urge to do…well, something! Just make sure that the “something” is done for rational reasons.

If you find that one of your mutual funds is performing poorly for a given time period, what should you do? Best advice is to start with the reasons for choosing your mutual fund and then determine if anything has changed.

Figuring out the Why

One of the hard and fast rules for actively managed mutual funds is that at some point in time even the best managed funds will underperform, sometimes quite dramatically. Studies have looked at top performing funds over ten-year periods and noted that virtually all spend some time within that ten years (e.g. for three years within the ten) near the bottom in terms of performance. Even knowing this, it is very difficult to look back on a year when the market was up and feel good about your fund being down.

Suggestion: Come up with a checklist when you buy a fund. Note the reasons for buying, e.g. strong management, consistent performance, skill at investing in a certain segment of the market, low turnover, etc. If you then see a period of poor performance, you can reference your checklist and make sure that the reasons for buying the fund remain valid. If nothing has changed, then perhaps this is just a normal hiccup and you will be rewarded for holding. If those purchasing factors now appear less attractive, then perhaps you can rationally justify selling your position.

Current Case Study – Sequoia Fund

First some background. Sequoia Fund (ticker: SEQUX) is a legendary mutual fund. It was originally founded in July 1970 for the express purpose of taking on investors from Warren Buffett’s investment partnership. Mr. Buffett closed his partnership in order to focus on a small textile company he had purchased – Berkshire Hathaway.

Sequoia’s long term performance has been outstanding. From inception through December 2015 it returned 14.01% annually, easily outpacing the S&P 500’s return of 10.75% per year. While that may not seem like a big gap, the power of compounding over 35 years means that investors in Sequoia would have ended 2015 with more than three times the money of those who invested in the S&P 500 index.

Over the years, the fund was known for its concentrated bets and low turnover. It tended to hold large positions (percentage-wise) in a small number of names. For decades that approach worked well.

Big Bet Goes Bad

Lately Sequoia has been in the news for less glowing reasons. Through the end of the first quarter, its one, three, and five year performance numbers all fall in the bottom decile versus its peer group. The blame for this downturn lands squarely at the feet of one stock: Valeant Pharmaceuticals (VRX).

Sequoia first purchased Valeant in 2010. The stock was a big winner, rising over 900% through July 2015. During that time, the Valeant position ballooned to over 30% of the fund’s assets. Unfortunately, Valeant’s subsequent performance has been horrific, with the stock falling 90% from its high. To understate the obvious, a 90% drop for a stock representing 30% of your portfolio will have an adverse impact on performance!

The Aftermath

Near the end of the first quarter of 2016, Sequoia announced the resignation of one of its co-managers. The fund released a letter to its shareholders that specifically discussed the fund’s investment in Valeant, its impact on performance, and lessons learned.

The Future

So what is a shareholder to do? Obviously there are no guarantees in life. But a few items are worth noting here. First, this is not the first time that Sequoia has underperformed dramatically. It has recovered from each prior episode.

Second, while one portfolio manager has left Sequoia the remaining manager has been in his position for nearly 10 years, so he is not an unknown quantity. Third, the fund has a strong team of long-tenured analysts as well, so the portfolio manager is not operating on his own. In other words, a lot of the talent that helped to build the outstanding long-term track record remains in place.

Finally, the company seems to have learned some hard lessons from their recent travails. One example - a recent article suggested that they would be putting limits on how much to invest in a single stock. Again, there are no guarantees, but perhaps a return to glory is not out of the question. Time will tell.

Summary

Long-term success as an investor depends on rational decision-making. Remaining focused on the reasons for purchasing a mutual fund will help you determine the appropriate action when its performance lags expectations. And, most important, remember not to let frustrations and emotions override your investing intelligence.

Contact Us | About Us

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this article will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any information or any corresponding discussions serves as the receipt of, or as a substitute for, personalized investment advice from Bedel Financial Consulting, Inc. Portfolio Managers. The opinions expressed are those of Bedel Financial Consulting, Inc. and are subject to change at any time due to the changes in market or economic conditions.

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