While no one will ever pick all the winners at the right time, or kick out all the losers before they have done damage, there are several steps investors can take to protect their capital.
Hargreaves Lansdown’s Adrian Lowcock and FE Alpha Manager David Coombs explain what these are.
How to spot an underperforming fund
"It’s very difficult to spot an underperforming fund early because you’ve always got to give the manager time to do something," said Lowcock (pictured).
"I wouldn’t remove an underperforming fund quickly just because it’s underperforming. Instead, you need to look at why it’s underperforming."Lowcock says that over the short-term there are two reasons why a fund can underperform. Either there has been an unfortunate incident that has affected one or more holdings in the portfolio or the manager has missed out on part of the rally.
In recent months, for example, managers that steered clear of financials have underperformed their peers as the out-of-favour sector surged.
Lowcock says it is only when consistent underperformance reaches its third year that investors should take stock of a lagging fund.
"Consistent underperformance of three years or longer will give you an idea of whether or not you need to get out," he said.
Lowcock says that before investors take a knee-jerk reaction and pull their money out, they need to evaluate whether the manager’s style is just out of fashion at the moment or if there is something the manager is doing wrong.
In the latter case, Lowcock says, investors need to question if the manager is doing something about it.
He adds that one of the best examples of this cyclical style-bias is FE Alpha Manager Neil Woodford.
"He has a famous high-conviction style and his approach will invariably be out of favour at different times."
Woodford's flagship five crown-rated Invesco Perpetual Income fund is a bottom-quartile performer in three of the last 10 years and second quartile over one.
His performance over the long-term is extremely positive, however, which shows the value of sticking with a manager when their style is out of fashion.
Since 1995, the fund has made 701.1 per cent while the IMA UK Equity Income sector has only picked up 319.33 per cent.
The fund’s benchmark, the FTSE All Share, made even less over the period – just 305.9 per cent, according to FE Analytics.
Performance of fund vs sector and index since 1995
Source: FE Analytics
David Coombs (pictured), head of multi-manager at Rathbones, says there are a number of reasons why he would kick out a portfolio, but underperformance is not one of them.
"I’ve sold funds because the manager has got distracted by the marketing issues and sold funds because they’ve got too big," he said. "But I don’t think I’ve ever sold a fund just for bad performance." "You need to have patience. But it’s hard to have patience when managers are set against quartiles."
Selling an outperforming fund
Lowcock says investors need to keep tabs on the size of individual holdings in their portfolios.
"You need to ask yourself how much exposure do you have to that investment compared with other assets," he said.
"You shouldn’t have more than 10 per cent in any one fund."
Lowcock adds that when a fund has been outperforming over a period of six months to three years, it is a good idea to take profits in order to protect capital in case the market turns.
"If you don’t, the market will do it for you," he added.
Lowcock says commodities are a prime example of an area where it pays for investors to hedge their gains.
JPM Natural Resources, for example, has strongly outperformed the HSBC Gold Mining & Energy index over 10 years. However, the fund has lost money over one, three and five years.
Investors who had not taken any profits would have seen their stake more than halve in 2008.
The same is true of the years following the credit crunch. The fund more than doubled the performance of the HSBC Gold Mining & Energy index in 2009, and strongly outperformed in 2010, but took a heavy hit again in 2011.
Lowcock stresses that taking profits from a fund is not the same thing as selling it outright.
Instead, investors should manage the percentage of a holding in their portfolio and keep their winners over the extreme long-term.
He says that if a holding begins at around 5 per cent of a portfolio, there is room for it to grow.
"But once it starts going to 10 per cent or above, that’s a sign that you should be rebalancing to other areas," he added.
Lowcock says that assets should never be valued on their own merit and that investors need to look at how the portfolio works together as a whole.
He adds that as some asset classes get more expensive, investors should look to take profits to pre-empt a fall.
"You’re never going to get your full return, but no one ever does. What’s more important is making sure you don’t lose all your profits," he explained.
He says anyone who has invested in gilts over the last several years has benefited from a risk in the market, but that this is a signal to take some profit.
When it comes to outperforming funds, Coombs says he asks several questions, the first of which is whether to sell it.
"If the manager has been taking profits, that’s OK. I don’t need to be taking profits if they are," he said.
He adds that there are times when the opposite is true and it is best for investors to quit when they are ahead.
When to rebalance your portfolio
Lowcock advises investors to review their portfolio at least once a quarter to make sure nothing is glaringly wrong.
"You should then do a more detailed check twice a year," he said.
He adds that investors should consider what stage of their life they are in before they shift their holdings around; for example, someone who is still paying money into their portfolio should look to hold on to their existing investments and put the new money into different areas.
"As long as a manager is still good, use the new money to increase exposure in other areas. The new money acts as a rebalancing tool," he said.
He advises anyone who has retired or who is entering retirement to actively manage their portfolio and take profits from their winners to protect their capital.
He adds that all investors should be keeping a little bit of cash aside with the view of pushing in to the market if it takes a tumble.
"Don’t try and predict when markets correct, but if they do correct, be ready to invest," he said.