FINANCIAL PROBLEM SOLVED!

"We don't know what funds to keep"

Problem

I'm soon to marry for the second time. I have 12 mutual funds, totaling about $650,000, that are divided between a tax-deferred and a taxable account. My fiancee also owns 12 funds. Hers total about $300,000 and are all in a taxable account. Should we combine our funds into a single portfolio? If so, how do we decide which funds to keep and which to get rid of?

Solution

You and your fiancee should look at your investments as a coordinated, diversified portfolio. This portfolio doesn't need 24 mutual funds. Many of the funds you two own probably share the same objectives. They may even have identical holdings, meaning you're not getting the value of diversification. At most, aim for about 12 funds in total.

Here's how to pare your holdings: First, look at each fund's objective, and group the funds by category. That way, you can compare each one's performance to its peers (check Morningstar, available in many libraries or online at www.morningstar.com) and to the appropriate benchmark. Keeping one or two funds from each category should be sufficient.

For example, if a fund invests in large-cap growth stocks, compare its performance to the Russell 1000 Growth Index; if it's a large-cap value fund, compare it to the Russell 1000 Value Index. Check the fund's prospectus or the company's Web site for the appropriate benchmark.

If a fund trails its benchmark by more than 1 or 2 percentage points annualized over three and five years, it's a candidate for paring.

If you're not sure of a fund's objective, check the prospectus, the fund company's Web site, or ask your financial adviser. The fund's objective may have changed over the years, so be sure you have up-to-date information.

Your portfolio should also have several distinct asset classes. The equity portion should consist of large-cap growth, large-cap value, small-to-mid-cap growth, small-to-mid-cap value, global growth, and global value funds. The bond portion should contain short-term US and foreign bonds. You should also have a real estate fund.

Before you make a decision on which funds to keep, look at each fund's expense ratio. Expenses can drag down performance, so favor funds with low expenses. Average expense ratios are 1.1 percent for taxable bond funds, 1.5 percent for domestic stock funds, and 1.9 percent for international stock funds.^*

Look, too, at the fund's manager. Is he the same person who built the fund's track record, or is he brand new? If the manager is new, find out what funds he previously directed. This doesn't mean you must sell a fund just because the manager has changed. However, if you already own a fund with a similar mandate, strong performance, and a tried-and-true manager, why take a chance with someone who's unproven?

Finally, consider the fund's tax status. If you have two funds with similar objectives and comparable returns, but one's in a tax-deferred account and the other's not, you're better off keeping the tax-deferred fund, unless its performance is clearly lagging.

Once you've decided which funds to sell, consider the tax consequence of the sale. You can sell mutual funds in a tax-deferred account without a tax hit, but you may incur a taxable capital gain on funds you sell in the taxable account. If you're selling a fund that has a gain, try to offset that gain by also selling a fund that has a loss.

*As of Dec. 31, 2002. Source: Morningstar

This month's problem solver is David W. Polstra, CFP, CPA/PFS (davidp@pdllc.com) of Polstra & Dardaman, in Norcross, GA. Financial Problem Solved! is edited by Senior Editor Leslie Kane.

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David Polstra. Financial Problem Solved! "We don't know what funds to keep".

Medical Economics

Feb. 21, 2003;80:76.