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Time to Sweep Out Bad Funds

Pretty soon, you'll be getting a quarterly letter from your fund manager, bragging about how well he has done this year. He'll talk about all the great stocks in the portfolio. He'll promise to do his very best for you.

You might want to dump him anyway.

The fund industry is fond of promoting long-term investing - which is, indeed, a virtue. But there's no reason to be a long-term investor in a rotten fund, or in a fund that no longer suits your needs. And you can get significant tax benefits from selling a losing fund.

So pull out your fund statements. Grab a quart of Cherry Garcia and some tissues. It may be time to bid your fund goodbye. Fortunately, there are plenty of other fish in the mutual fund sea.

The average stock fund has jumped 21.6 percent this year, and 55 percent since the Standard&Poor's 500-stock index bottomed on March 9. That's pretty good.

But we're not talking about the average fund. We're talking about your fund. And when you have your choice of more than 4,300 U.S. stock funds, there's no need to settle for losers.

You shouldn't fire a fund manager if he lags behind other, similar funds for six months, or even a year. Even great managers have their off periods.

But many fund companies will fire a manager if he lags behind his competition for three years or longer. You should, too.

The funds in the chart have lagged behind their peers for the past one, three and five years, which is reason enough to sell them. But they also have another strike against them: above-average expenses.

Every fund charges expenses to pay for its operations: postage, rent, salaries and the like. But those expenses are a drag on performance. Most managers can't beat the S&P 500 by even half a percentage point a year. The job is far harder when the fund is taking 1.5 percentage points or more for expenses.

Over the long term, fees slash your returns. Consider two funds, each of which averages an 8 percent gain each year. Fund A charges 0.75 percent a year. Fund B charges 1.5 percent a year. A $10,000 investment in Fund A will grow to $81,643 in 30 years. Fund B will grow to $66,144, about 20 percent less.

You should also sell duplicate or unwanted funds. Because most people buy funds and don't sell them, they create the financial equivalent of a messy closet, filled with funds that no longer fit their goals.

Sector funds, for instance, aren't good long-term holdings, because sooner or later, they will go out of style, saddling you with long-term losses. If you think the fund has had its day, sell it and put your money to work elsewhere.

And if you have a dozen or more diversified funds, those, too, will reduce your portfolio's performance. When you own many similar funds, your returns will duplicate a broad-based market index - minus expenses. You're better off buying one or two low-cost index funds.

Finally, you can get substantial cash for your mutual fund clunkers. If your fund has posted a loss this year and it's in a taxable account, consider selling it - even if you like the fund.

When you sell your fund at a loss - short term or long term - you can use that loss to reduce your 2009 tax bill. You can use your losses to offset any amount of capital gains. And if you have no gains, you can deduct $3,000 of your losses from your income, thereby reducing your taxes.

For example, suppose you sell your fund for a $10,000 loss. You also have $4,000 in capital gains from selling other funds. You can:

- Use $4,000 of your loss to eliminate your capital gains.

- Deduct $3,000 of your loss from your income.

- Use the remaining $3,000 of your loss in the 2010 tax year.

If you still think the fund has potential, you can repurchase it. But you have to wait at least 30 days, or the IRS will consider the transaction a wash sale and disallow the loss.

The tax rate on most capital gains is 15 percent, the lowest rate in decades. Given the government's growing debt, the odds are good that eventually the capital gains rate will rise.

If that's the case, you might also consider taking some profits from some of your winning funds now, paying the tax and repurchasing the funds after 30 days have passed. Better yet, use any losses to eliminate the taxes on your gains.

It's always hard to say goodbye to an old fund. But if you really miss it, you can always renew your friendship after 30 days.

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