FOOL'S EYE VIEW
When To Switch Funds

By Stuart Watson (TMFTiger)
December 11, 2001

One of the commonest questions we get on our discussion boards goes something like "I put some money into an ISA two years ago and I've lost 15%/20%/25% of my money. Should I just cut my losses and move to another fund that is doing much better?" There are many problems with this question. For example, even though your fund may have lost money it may not have done badly compared to other funds. It does not follow that even if it has done badly recently that it will continue to do so in future, or that you'll be able to choose a fund that will do better. After all, if you've had trouble picking a good fund in the first place what makes you think you'll do better second time around?

Take a cue from house prices

In order to see why poor recent performance is not a good indicator of what will happen next let's look at the recent history of house prices. At the end of 1990 the average house price was around £69,000, according to the Halifax. Five years later it had fallen to £61,500. So would you deduce that houses were a bad investment in 1995, simply because they had fallen in value? Or would you think that perhaps they might have been overvalued in 1990 and offered good value for money in 1995? It looks like the latter was the more plausible explanation. By the end of 2000 the average house price had risen to £86,000. Investments need to be considered on the basis of where they are now, not on what they have just done.

Compare your fund against the FTSE

Even if your fund has lost money, it may only have fallen in line with the stock market as a whole. The table below shows the performance of the UK market from March each year to the end of last month, so you can see how your fund compares. If you've reinvested your dividends (through an accumulation unit trust for example) you need to use the higher figures.

Date                Change        Change
invested           without         with
                  dividends     dividends

Mar 96                41%           64%
Mar 97                21%           36%
Mar 98               -12%           -4%
Mar 99               -17%          -12%
Mar 00               -20%          -17%
Mar 01                -8%           -6%

So if you've invested any money in a share ISA in the last four ISA seasons and you've made money then you have done pretty well. The figures above don't include any charges either. If you'd invested in a fund in March 1998 and reinvested your dividends then you might be down by 10%, or possibly even more, after charges have taken their bite. Shares don't always go up in a nice straight line, although anyone investing in the last twenty years might have assumed that they did.

It's also worth noting how much difference dividends can make. If you're not reinvesting your dividends you are effectively taking money out the market and this significantly reduces your long-term performance.

Is it worth switching?

Now you've got a better idea of how your funds have performed what can you learn from that? If they have done worse than the market should you look elsewhere? If they have done better should you consider investing more? Just as markets have their good and bad periods, so do individual funds. Very often a period of good relative performance is followed by a poorer one and vice versa. By selling a fund that has done badly you could be doing the equivalent of bailing out of the housing market in 1995.

But the poor performance of your fund could be due to high charges, especially if you are looking at longer-term periods. There is no evidence that high-charging funds do any better than those with low charges. So why handicap your performance unnecessarily? A switch to a low cost fund can improve your chance of getting a better long-term return. (I would define a low-cost fund as one with no initial charge and annual charges of 1% or less).

Many pundits recommend regular switching to funds that they believe will outperform the market. There are two problems with this. First of all no one knows what the future holds and their view is only a best guess, with the emphasis on guess. It's tempting to think that the experts have some special insight into the future but the fact is they do not, as you'll see for yourself whenever the previous year's hot fund tips get the post-mortem treatment. Secondly, in order to beat the market you have to go for a fund that is actively managed. This means the charges will be higher and you'll also incur a cost for switching due to the new fund's initial charge. In other words, you're giving yourself a further handicap.

Some of these funds will beat the market but a larger proportion of them don't. It is not an appetising bet to be perfectly honest. With a high-cost fund you have the hope of getting a market-beating return. With a low-cost fund you have the certainty of a better than average performance compared to all other funds. I know which option I prefer. So the answer to the question of "when should you switch funds" can perhaps be best answered by "when you discover you are paying too much for them".

Where Next?

The ISA Centre