Top 5 Reasons to Sell Mutual Funds

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Failing to recognize when to sell a mutual fund is one of the most common portfolio management mistakes investors make.

mutual fund investing mistakesOften, with the best of intentions in mind, long-term investors tend to employ buy-and-hold strategies and selling a fund feels like they are abandoning their planning objectives. However, being a long-term investor does not necessarily mean a holding mutual fund for the long term no matter what. In fact, not selling a bad fund can seriously undermine the investment objective itself.

Also, in scenarios where investors finally decide to dump their mutual fund dogs, they only make that decision after years of underperformance. Furthermore, poor performance is only one of the potential reasons to sell a mutual fund. Many other sell signals can arise before the fund actually begins its under-performance.

Here are the top five reasons to sell a mutual fund:

1. Sell a Mutual Fund if it Consistently Under-Performs its Benchmark

You might be happy with your fund’s performance, but how do you measure that performance? For example, you may be happy with a 10% return last year, but what if the average fund in the same category gained 20%?

A baseline that guides investment decisions and fund performance is wise. If the fund fails the benchmark because of consistent poor performance, sell it. For example, if you own an actively managed, large-cap stock fund, a typical and healthy benchmark for this is the S&P 500 Index.

Keep in mind that even the best fund managers lose to their respective benchmarks up to one out of every three to five years. Therefore, don’t panic if the one-year performance is below the benchmark.

But performance below the benchmark for two consecutive years should be a red flag.

2. Sell a Mutual Fund if the Fund Manager Changes

A change in managers for a passively managed fund, such as an index fund, is not a problem. On the other hand, a change in managers can be a huge problem for actively managed funds. When a lead manager stays on board for several months or even years to train the newly added managers to ensure continued success and stability, you can watch the fund performance closely after the change before selling shares.

Fund managers are especially crucial to performance when they are a perceived as the driving forces behind security selections. Notice the use of the word “perceived.” If Warren Buffett retired from Berkshire Hathaway (BRK.B), Charlie Munger might be perfectly suited to take the helm. Even so, just the perception and brand of Buffett’s name is enough to put negative pressure on Munger’s management of Berkshire’s performance.

3. Sell a Mutual Fund if it Gets Too Big

Don’t ignore asset bloat. In the world of mutual funds, smaller is often performs better than larger.

A typical scenario is a fund manager does well with security selection and timing for a few years, the fund attracts billions of dollars in assets, the mutual fund is too greedy to close the fund to new investors, and the assets under management get so big that the manager is forced to buy more holdings (often at increasingly higher market caps).

When a mutual fund’s asset under management gets too big, it starts to look and act like its benchmark index. In this case, the investor might as well just hold the index because the actively-managed version loses in performance because of the higher relative expenses.

What’s too big? Check the average AUMs for similar funds. For example, AUMs for large-cap funds range from $701 million to $1.2 billion. So, if assets are above $2 billion, you might want to consider moving on unless the fund closes to new investors or has historically performed well at that size.

4. Sell a Mutual Fund When You See Style Drift

When a mutual fund evolves from one style (such as mid-cap stocks) to another style (such as large-cap stocks), it’s called style drift, which can cause another portfolio problem called fund overlap.

For example, if you have a large-cap stock fund and a mid-cap stock fund in your portfolio and your mid-cap fund drifts in style to large-cap fund, you now have two funds with the same style (overlap), and your portfolio has become less diversified.

The most common cause of style drift is asset bloat. When assets grow too big, the manager buys larger capitalization stock and can eventually become too similar to a fund you may already hold.

5. Sell a Mutual Fund to Meet the Investment Objective

No matter what the reason for selling shares of a mutual fund, the investor’s investment objective — which includes time frame and risk tolerance — is the overriding decision factor ahead of the previous four reasons.

For example, when the investment objective is changing from growth to income, as in the case of an investor that is in or near retirement, there might be less need for aggressive stock funds and more need for dividend funds and fixed-income funds. Such planned shifts in investment style have nothing to do with the quality of the fund.

Other reasons to sell a mutual fund to meet the investment objective come in the form of short-term opportunities, such as tax loss harvesting. For example, if investors have funds sitting on capital losses, they can sell the shares to offset capital gains from the sale of another fund.

Above all, keep in mind that mutual funds are tools to help in achieving the overall investment objective. Any other reason to sell is secondary to this final rule.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.


Article printed from InvestorPlace Media, https://investorplace.com/2014/08/sell-mutual-funds/.

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