Ten Reasons To Sell A Mutual Fund Other Than Poor Performance

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Knowing when to sell a mutual fund can be complicated, even for savvy investors. Even if your mutual funds are performing well, it is important to keep an eye out for problems lurking below the surface.

The decision of when to sell a mutual fund is different than when to sell an individual stock. With individual stocks, price targets, valuation and short-term news can play a much greater role in the decision to sell, while mutual funds provide diversification to protect against fluctuations in any one individual stock.

With a mutual fund, it is important to step back and consider the fund as it is today, not as it was when you bought it. Ask yourself: Would I buy this fund today if I were starting over? If for any reason the answer is no, then it may make sense to sell. A portfolio is no place to get sentimental.

Many people unload mutual funds that are performing poorly, of course. But that is not the only reason for getting rid of a particular fund. Here are 10 other indicators it may be time to let a mutual fund go.

1. The fund performs well and your portfolio needs to be rebalanced. If the fund has performed very well, you will likely find yourself selling at least some of your position in the fund when you rebalance your portfolio in order to get your asset allocation back on target. While the decision of how often to rebalance is up to you, it is important to pay attention to fluctuations in your portfolio. By rebalancing regularly, you will continually be buying low and selling high, which should be your goal as an investor.

2. The fund performs exceptionally well – for all the wrong reasons. If the fund significantly outperforms other funds or the market in general, you may want to take a closer look to understand why it has done so well. Unfortunately, you may not like the answer. The fund manager may be taking risks you were not aware of and are not comfortable with. Exceedingly good performance, especially in the short term, may turn out to be a warning sign that leads to a sale.

3. You want to capture a capital loss. If a fund declines in value but continues to outperform its competition, selling for the capital loss in order to lower your tax bill makes sense. You can either buy the fund back after 30 days, or you can immediately buy a different fund that uses a similar strategy to maintain market exposure.

4. The fund manager changes. A manager change is not an automatic reason to sell, but you should take the time to make sure you are comfortable with the new manager. How experienced is she? Will she change the fund’s strategy? On a larger scale, sometimes entire fund companies are sold or merge with other companies. New company management can lead to changes in fund strategies, expenses or incentives.

Manager changes are a fact of life for a diversified mutual fund portfolio, as fund managers leave for other employment opportunities or retire. Some companies intentionally rotate managers across funds to develop their expertise in different strategies and industries. At Palisades Hudson, when we see a manager leave a mutual fund that we recommend, the rest of the management team typically remains in place or the new manager has previously been involved in some role in the fund’s management (for example, as an analyst). The new manager almost always will attempt to follow the same strategy as the previous manager, in order to ensure a smooth transition. We have chosen to sell certain funds as a result of a manager change, but the majority of the time we choose to monitor the fund to make sure the new manager does not deviate significantly from the previous manager’s strategy.

5. “Style drift” sets in. Fund strategies can change, and it is important to keep an eye on “style drift,” in which your fund gradually stops doing the things you want it to do. Actively managed funds are especially vulnerable to this phenomenon. While you want your fund manager to be flexible and aware of current market conditions, you also want a manager to be disciplined and stay true to the fund’s overall strategy. If a manager’s strategy has underperformed and, as a result, the manager gives in and decides to start following the herd, you may not see the results you anticipated. A manager following consensus opinions can lead to your fund becoming a “closet index fund” that charges higher fees but performs very similarly to its benchmark index. Usually these funds will slightly trail their benchmark because of high fees. If your fund is no longer adding value, you should look for cheaper or better-performing funds that can deliver what you want.

6. You are not comfortable with your fund’s investments. You should understand what your fund is doing. If your fund is investing in illiquid investments, derivatives or other securities that you are uncomfortable with, that is a legitimate reason to sell. If you want exposure to stocks or bonds, the fund should invest principally in stocks or bonds. Some funds mix in options, currencies, commodities or private securities at the margins to try and boost returns. These types of investments can cause problems down the road, especially if the fund experiences large redemptions and has to sell illiquid investments at fire-sale prices. If you do not want to take on this risk, look elsewhere.

7. The asset base has become too small. Small asset bases create problems, especially for actively managed funds. A small asset base can lead to large year-end capital gain distributions, especially if some shareholders hold large fund positions. You can find information on large fund shareholders in mutual fund disclosure documents. When funds must sell appreciated securities to meet large redemptions, all the remaining shareholders holding the fund in a taxable account suffer. Even in years with flat or negative performance, small funds may find themselves distributing 20 percent, 30 percent or more in capital gains. Because of this, our firm typically screens for actively managed funds with at least $200 million in assets.

Small asset bases also raise the risk of the fund terminating altogether, which can lead to realized gains. If you find out that your fund will soon terminate, we typically recommend selling immediately. As mutual funds wind down, they often have to do a lot of trading – which can lead to increased trading expenses – and hold significant cash stakes to meet redemptions. As an investor, it is better to cash out right away and reinvest in a different fund.

8. The asset base has become too large. Large asset bases can be a problem too, especially for actively managed funds that invest in smaller companies. As funds grow, it can be difficult to spread bets across many small companies and avoid taking a large ownership stake in any one of them. These funds often must buy an increasing number of stocks, which ends up diluting fund returns and making it more difficult for them to outperform their benchmark index. Because of this, we prefer actively managed mutual funds that invest in small companies to have asset bases of $2 billion or less. This limit can help them focus on the best small-cap stocks and ignore the rest.

9. Expenses increase. There has been a trend towards decreasing expenses in the mutual fund industry in recent years, but there are always outliers. If your fund raises expenses, evaluate what else is available. You may be able to find a fund pursuing a similar strategy for less, especially if you are comparing index funds.

10. You find a better fund. Better options do sometimes come along. Even if your fund is doing well, there may be other funds that offer stronger performance or lower expenses. While you may not always find something, it pays to regularly check for better investment options. There has been steep competition recently on annual fees among index mutual funds and exchange traded funds (ETFs), and investors have benefited. We have seen many cases of new ETFs undercutting older ETFs on fees, with many new funds charging 0.15 percent or less. If your index fund charges 0.50 percent or more per year, or if your actively managed mutual fund charges 1 percent or more, look for alternatives at least once a year.

Even if you are concerned about your fund, you may find that it remains the best option in its category. This is a frequent issue in employer-provided retirement plans such as 401(k)s, where investment options can be limited and an account holder may only have the option of one fund for a particular asset class. Sometimes you might decide not to liquidate your stake in a fund outright, but to stop buying any more of it. This allows you to avoid triggering the tax consequences (in taxable accounts) that a sale would create, while also limiting any additional exposure to the fund.

The decision of when to sell is not one-size-fits-all. Different investors can look at the same fund and come to different conclusions on whether or not to sell. But there are many legitimate reasons to unload a fund. Even if performance is not the problem, do not hesitate to make a move if it is the right thing to do.

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About Paul Jacobs 15 Articles

Affiliation: Palisades Hudson Financial Group

Paul Jacobs, CFP®, EA, joined Palisades Hudson as an associate in Scarsdale in 2002. In 2006 he became a client service manager and transferred to Fort Lauderdale. In 2008 Paul moved to Atlanta, where he is presently the client service manager in charge, to establish the firm’s office there.

As chief investment officer and chairman of the firm’s investment committee, Paul directs a team of portfolio managers and associates focused on finding the most efficient and cost-effective ways to implement client portfolio strategies. He oversees more than $1 billion in client assets, including all aspects of investment strategy, portfolio management, due diligence, and manager selection.

Paul formerly served as the firm’s Chief Compliance Officer, and he has had extensive experience in the firm’s investment management and tax compliance practices. His additional responsibilities include developing and monitoring client portfolios, reviewing tax strategies and returns for clients, and developing comprehensive personal financial plans. He also has worked on client projects involving charitable planning, bookkeeping, retirement planning, and estate planning and administration.

Paul graduated from New York University’s Stern School of Business with degrees in finance and accounting. He is a CERTIFIED FINANCIAL PLANNER® certificant, an Enrolled Agent and a member of the Financial Planning Association of Georgia.

Paul is the author or co-author of numerous Sentinel articles, including “Pay As You Go: Tax Rules Upon Expatriation” (June 2012), “Beware Mutual Funds Using Hedge Fund Strategies” (January 2012), “Is There A Bubble In The Bond Market?” (October 2010), “Should You Do A Roth IRA Conversion?” (February 2010), and “Private Equity In A Deleveraged World” (April 2009).

Visit: Palisades Hudson

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