Fund Holding Periods for
Upgraders Getting Shorter

One of our goals in Upgrading is to hold as many of our recommended funds as possible for at least 12 months in order to qualify for long-term capital gains tax treatment. Unfortunately, that doesn't always happen. In fact, in doing the research for The Cost of Failing to Act Promptly Can Add Up , I discovered we've been averaging less than 10 months per fund of late. Here are the details.

There were 47 funds sold in 2003-2004. These funds were held an average of 10 months. That is significantly shorter than the 15 month average holding period of the funds sold from 2000-2002. What explains the difference? I don't know the answer for sure, but I have a couple of theories. One is that when the market makes a marked shift in direction, turnover will be higher. This is most clearly seen in 2003, when the market shifted from full-fledged bear to roaring bull. That year saw 25 funds sold—the most of any year in the past five. As a result, the average holding period of the funds sold in 2003 was just 9 months, notably shorter than any other year. That makes sense intuitively—we shifted the entire portfolio from conservative funds that had played good defense to more aggressive funds that could play good offense.

There is also evidence to support that theory in the results from 2000. As the bull market came to a close, the funds that had been held during the last leg of the bull were gradually sold. The market had been going straight up for some time, and as a result, there hadn't been as much turnover as usual. So those funds sold in 2000 had an abnormally long average holding period of 17 months.

A second theory as to why average holding periods may be down has to do with our increased reliance on the momentum scores over the past few years. In 2001, Morningstar changed some things in their data service that allowed us to start calculating the "true" momentum scores again after several years of not being able to. I think it's safe to say Austin and I are a lot less forgiving about selling underperforming funds now than we were prior to that point when the momentum numbers were unavailable. Over the past few years, we've also been able to do several studies with historical data regarding different fund momentum ideas, and those studies have only solidified our convictions about sticking closely to the momentum scores. There's no question that the number of funds sold in 2002-2004 has been higher than in 2000-2001. At least part of that is probably attributable to our increased reliance on the momentum numbers.

What any of this means for the future is less clear. It could be that we'll continue to have less funds make it to a 12 months holding period. While we do watch that, it's not our primary consideration in whether we sell or hold. Then again, the market could establish a clearer direction and our average holding periods could go back up. With the exception of the strong move up in the fourth quarter of last year, the market has been churning up and down repeatedly since the beginning of 2004. That's not the kind of environment that's conducive to long holding periods.

• Got a question or comment about this article? Discuss it on our Message Boards.