An important question we usually ask the portfolio managers of the mutual funds that we invest in is: "When do you think it would be an appropriate time for us to redeem your fund?"

This question catches them off guard quite often. But it shouldn’t. We never want to buy a fund without knowing why we would sell it. No matter how good a fund is, there is always the possibility that under certain circumstances, it won’t make sense in a given portfolio. Regardless of how they respond to our question we go on to explain exactly what circumstances might prompt us to sell their fund. It’s an important discussion to have so we can minimize any surprises and build a lasting relationship.

Why We Would Sell A Fund In Your Portfolio
There are a wide variety of factors that might cause us to sell a fund in your portfolio, but they fall into two broad categories. One category of factors is a change in the fund itself, either in terms of its management or its behavior. The other category of factors relate to the application of our overall portfolio strategy and management process.

Changes In The Fund
First, and most obvious, a significant organizational or manager change will cause us to reevaluate a fund. This is critical, as the talent behind a fund’s behavior and success is often the most important variable. An example of a fund we sold in recent years due to an organizational change was Janus High Yield. The fund’s manager, Sandy Rufenacht, was a highly regarded high-yield investor and someone we personally respected a great deal. When we heard through the industry grapevine that Sandy was stepping down and that the new manager had a vastly different style to running money, we quickly liquidated our position. Not only were we concerned that a rash of potential redemptions could significantly compromise performance, but the new style and likely behavior of the fund was not what we desired for our client portfolios.

Equally important, but much harder to detect, is a philosophical change in the fund’s investment process. Very few firms will admit that they have changed their investment strategy, but the reality is quite different. It is remarkable how many investment processes are "enhanced," not for real investment reasons, but due to business pressures (an out-of-favor investment style causing declining assets for instance) or performance-chasing (yes, even experienced, highly credentialed veterans can succumb to this!).

We have seen plenty of examples here, but one that stands out affected nearly a whole investment class! In the late 1990s, many, many value managers changed their approach to the market so they could somehow justify buying technology stocks. The concept of "relative" value became the new mantra. Sure, Big Idea.com was selling at 250x sales (forget earnings there weren’t any), but that was less than the 400x sales that other companies in that sector were selling for so, "voila," it was a value stock! Interestingly, shortly after they made those changes, technology vastly underperformed the very "real" value stocks they sold to buy technology. They should have stayed disciplined!

Another warning sign is unexpected fund behavior. If the fund doesn’t act the way we thought it would, we start asking questions. (By the way that is usually how we detect the changes in investment philosophy described above). Were the fund’s market exposures or risk characteristics different from what we expected and from what we wanted for that fund’s role in your portfolio? As an analyst of managers, many think our job number one is to pick top performing funds. That is indeed important, but it is even more important to understand a fund’s characteristics and how it interacts with the other funds in your portfolio. If we get that wrong -- which should be the easy part -- your over-all portfolio will not behave as we expected. Fortunately, we don’t have too many examples here, but we still do have some.

Several years ago, we purchased a fund with a unique strategy that was new to the marketplace. After crunching a lot of numbers and having several discussions with the manager regarding our expectations for the fund, we felt we knew how the fund would behave. In short, we didn’t get it right. The fund actually exhibited more volatility than we anticipated, and after talking to the manager again, we decided that the fund’s attributes would simply be too slippery to work with moving forward.

Another reason for concern is when a fund’s returns are significantly worse -- or better! -- than our expectations. Why would we be concerned if returns were a lot better? Well that may well be a tip off that the fund manager is not pursuing the investment strategy they told us they would follow. The example of the value managers noted above is a case-in-point. Those "value" managers that were actually buying growth companies in sheep’s clothing were way outperforming other value managers as a result (at least for a while!). The point is, that in your portfolio we would already have funds that filled out the growth segment. If a fund we owned to fill a value role was actually acting more like a growth fund, your portfolio would be dangerously overweighted towards growth.

However, if a fund’s return isn’t up to snuff, we don’t automatically sell, either. We first look to see if there was a good reason why returns are off. For example, in some client portfolios, we own a value fund that has slightly underperformed this year. While of course we are still disappointed in the relative performance, there is a solid reason why it has underperformed. This portfolio manager consistently buys higher quality companies (as defined by more sustainable and less volatile margins and earnings), but within the value sector, the market has been favoring lower quality, more cyclical names. However, given our market outlook moving forward, we are comfortable maintaining exposure to higher quality companies and so this fund still makes sense.

Lastly, it is very important to pay attention to a fund’s asset base. In some asset classes, or parts of the market, this is a critical consideration. A small cap fund, for instance, can have a difficult time achieving above average returns when its asset base becomes bloated. A large asset base makes it much more difficult to quickly get in and out of the many relatively illiquid names that populate the small cap market. In short, once assets come pouring in, it’s a rare manager indeed who can maintain the returns they achieved when their fund was small.

The Application Of Our Portfolio Strategy And Management
Obviously, if we have a change in our market outlook, we will most likely want to re-shape the over-all market exposures of your portfolio. For instance, in a number of client portfolios we recently adjusted our fixed-income exposure by trimming some of our existing bond positions and placing the proceeds into a money market account. While there are many good reasons for adding cash to these accounts, our prime objective was to effectively enhance the credit quality and lower the duration (a measure similar to maturity, but a better reflection of interest rate sensitivity) of the portfolios’ overall fixed-income position.

Even if our strategy hasn’t changed, we may still need to "re-balance" your portfolio to manage its over-all risk characteristics. For example, market action (i.e., growth stocks performing really well) may cause the relative volatility of the over-all portfolio to get out of whack with our expectations and outlook. In that case, we may trim some positions, or perhaps exchange one fund for another, to bring the portfolio’s volatility back in line.

A common reason for turnover in recent years is that we manage taxable portfolios to "harvest" tax losses all year long. While we have no hard and fast rule, and make separate decisions on each individual situation, generally if a fund is trading at a 10% loss or more from cost, we will sell that fund immediately and use that loss to offset any gains in your portfolio (past or future). We will purchase a substitute fund at that point to maintain the desired market exposure for your portfolio. We may, or may not, go back to the original fund later.

Last, but certainly not the least important, in managing your portfolios we are always looking for "a better idea." We have eight people on staff meeting with portfolio managers, analyzing data, and making investment recommendations. We participate in 600-700 portfolio manager meetings or presentations each year. We hear lots of ideas and are always trying to find funds that might be appropriate to add at the right time and place. So we may sell a fund that has done nothing "wrong" because we feel we can improve the overall quality of your portfolio with a different choice.

What Should Be Your Sell Discipline With Us?
In much the same way as we believe it is important to be clear with the managers we invest with about our expectations and what would cause us to leave, we think you should do the same with us. While there are some obvious similarities to the sell discipline we employ with individual funds, because we are a manger of multi-fund portfolios, there are some differences to take into account.

Here are four basic questions we suggest that you should always be asking from an investment standpoint:

1. Is my asset allocation appropriate?
   Determining the right allocation for you requires on-going communication and effort on both parties’ behalf. You and your Account Manager should discuss in depth your personal situation, including your financial objectives, time horizon, risk tolerances, constraints, complete portfolio (including investments that will not be managed by KIM) and many other factors. If armed with that information, we then place you in an asset allocation that you either do not understand or are not comfortable with, that would qualify as a legitimate reason to look for another money manager.

2. In terms of risk, is my portfolio behaving as I thought it would?
   Once we have agreed on your asset allocation and have explained it to your satisfaction, we will start managing your portfolio. If after a reasonable amount of time, your portfolio’s risk characteristics (relative volatility for instance) do not match what you understood them to be - given our investment process and market outlook - you should ask us why they haven’t. If our explanation of the reasons for any deviation is not sound, that would also qualify as a reason to leave.

3. Are my returns reasonable?
   Given the risk characteristics and market exposures of your portfolio, is your total return (after-tax return, if applicable) reasonable over a full market cycle? If not, you should again ask us why not? Were the unexpected results, either good or bad, a product of the consistent application of a thoughtful, logical and disciplined investment process? If you don’t believe so, a new manager may be in order.

4. Lastly, am I comfortable with your investment process?
   With respect to returns, you should recognize that all money managers underperform at some point. Nobody hits the cover off the ball every year. That is why it is very important that you are comfortable that the research infrastructure and decision-making process working on your behalf is sound. If you don’t believe that our process offer you the appropriate discipline, personalization and convenience (and at a reasonable price) then it may be time to look elsewhere.

When assessing a money manager, most investors think that the only number to look at is total return – even over short time frames. In the end, what is important is that your return is sufficient to enable you to reach your financial objectives. And that depends not just on your expected returns, but on how risk is managed in trying to achieve those returns. If your asset allocation is appropriate and the decisions on selecting funds, market exposures, and controlling risk characteristics are determined by a sound investment process, then over time, your returns should, in fact, enable you to reach your goals.