16 Reasons You Should
Sell a Mutual Fund
16 Reasons You Should
Sell a Mutual Fund
by Paul A. Merriman, Editor
Fund Exchange
Everybody seems to want you to buy
mutual funds. the advertisements and sales pitches in newspapers, magazines
and in the offices of financial planners all tell you to buy. The articles
in the popular and financial press tell you to buy. but in the life of every
investor there is a time to buy and there is a time to sell--and the selling
decision gets short shrift in the financial publications. The articles that
tout the "best funds to buy now" rarely are followed up later
with articles on which of those funds to sell, and when.
Many financial writers, brokers and financial planners seem to think
it's a serious mistake to recommend buying some financial product, and later
to recommend selling it. Even though this is the most natural sequence of
events, the emphasis is on dreams and hopes (which lead to purchases), not
on the need to evaluate a portfolio and make it stronger.
So this month, we're going to discuss selling mutual funds. We'll talk
about when to do it and why. And we'll discuss which funds to sell, if you
have a choice. If you don't plan to unload your investments any time soon,
you might think this is irrelevant to you. But the proper management of
your portfolio may require you to sell funds from time to time even if you
don't plan to get out of the market. And understanding when and what to
sell will make you a better buyer of mutual funds as well as a savvy seller.
Here's one more point before we get to the 16 reasons to sell: I don't
think there should be any more stigma attached to selling an investment
than to buying one. In either case, when you do it for the right reasons,
you're improving your position. And in either case, if you do it for the
wrong reasons, you could be inviting unwanted trouble.
Reason 1: Consider selling a fund if it doesn't belong in
your asset allocation. This is the most fundamental reason for selling,
and it's at the core of everything else we have to say here. To use an easy
example, suppose you determine that the fixed-income part of your portfolio
should be entirely in municipal bond funds because you want to minimize
the taxes on your investment income, yet you currently own shares in a high-grade
corporate bond fund. Your current fund is not suited to your needs because
it generates taxable income, and plenty of it. Your obvious best move is
to sell the high-grade fund and replace it with a muni-bond fund.
Here is a less obvious example: Your emergency funds are in a money
market fund, and you're willing to experience a slight bit of volatility
for higher return. Sell the money market fund shares, and park your cash
in an ultra-short-term or short-term bond fund. Unless you are hit be a
big upward swing in interest rates, you'll get as much as 1 percent higher
return with very little extra long-term risk.
Likewise with equities. If your asset allocation calls for 50 percent
of your equity investments to be outside the United States, yet two-thirds
of your portfolio is invested in index funds tied to the Standard &
Poor's 500 Index, you're off the track. You should sell enough shares to
bring your balance into line and invest the proceeds in international funds.
Reason 2: Consider selling a fund if its expenses are too
high. During the past few years of generally high performance, most
mutual fund investors have ignored expenses. Don't do that. Fund expenses,
whether they are in the form of 12b-1 fees or operating expenses, come out
of your pocket and decrease your returns. Don't give a fund the axe just
because of its expenses. but if you find a second fund that's equally suitable
for your needs, it may be time to sell the one with higher expenses.
Reason 3: Consider selling a fund with low tax efficiency.
Tax efficiency is the ability of a fund to generate returns for an investor
without generating a tax liability in the process. This is usually related
to portfolio turnover, but high turnover doesn't necessarily mean low tax
efficiency.
Imagine two small-cap stock funds with identical returns of, say, 16
percent. To simplify, imagine they have similar net asset values (NAV) of
about $25. One fund distributes $1.25 per share in capital gains, or about
five percent of its value. The other distributes only 50 cents in capital
gains in the same period, or 2 percent of its value. Assuming the distributions
were reinvested, each fund would leave investors in equal positions, right?
Wrong. Assuming an investor owned 100 shares of each fund, he would have
a taxable capital gain of $125 in one fund but only $50 in the other. That
means a tax liability of $25 in one fund (assuming a 20 percent capital
gains rate) and $10 in the other.
The bottom line: If everything else is equal sell the fund that's least
tax efficient. The formula is easy: Total a fund's dividends and capital
gains distributions over a period of three to five years and divide by the
average NAV during that time. The lower the number, the less you'll pay
in taxes. When you're comparing funds, be sure you're comparing identical
periods.
Reason 4: Consider selling a fund that consistently underperforms
its peers. Don't get me wrong. I am not advocating that you jump on
the bandwagon of performance. As we've done our best to demonstrate and
explain, past performance is not a reliable guide to future performance.
With that said, if year after year your fund winds up in the lower half
of performance among other funds that are truly comparable and suitable
for your needs, you should probably sell it and buy one that performs better.
The danger is that, if you're as addicted to raw performance as most
mutual fund investors are, you could be tempted to ignore everything else
on this list and simply chase performance. But if our goal is to be a savvy
fund investor and get the best results over time, don't replace one fund
with another just because of performance. Go through all the issues on this
list and then make your decision.
Reason 5: Consider selling a fund if its style is drifting.
This is a variation on Reason 1. Here's an example. A few years ago the
manager of Fidelity Magellan decided the time was right to load up on bonds.
In less than a year, Magellan went from being a stock fund to a balanced
fund, with more than a third of its portfolio invested in bonds. The manager's
timing turned out to be awful, and soon he was looking for a new job. Even
though this was perfectly legal, the fund made a major change in the nature
of its portfolio without any change in its prospectus or its name, and without
a vote of shareholders.
A change in style isn't intrinsically bad, and some nimble money mangers
have been able to successfully move from one sector to another to bolster
their returns. However, a fund like that does not fit well into a carefully
crafted asset allocation plan. For instance, if you had used Magellan as
part of your equity allocation, when it shifted into bonds you would have
been unbalanced. If Magellan's bet on bonds had been successful, you might
not have minded. But you would not have gotten the allocation you had determined
was in your best interest.
Here's the bottom line. If you're serious about asset allocation (and
you should be), stick to funds that are committed to a particular class
of asset. Here's an extreme hypothetical example. If you bought a money
market fund for strict stability, you would sell if the fund manager started
adding initial public offerings of technology stocks to the portfolio. Likewise,
if you buy a small-cap value fund and later find that it is investing in
mid-cap growth stocks, sell that fund and take your money elsewhere. And
if you're committed to a particular fund that (like Magellan) gives its
manager the freedom to move about from one asset class to another, add a
new category to your overall asset allocation strategy. You could call it
something like "expedient investments depending on beliefs of the manager."
Reason 6: Consider selling an actively managed fund (as opposed
to an index fund) if the portfolio manager changes. This does not mean
a change of manager is an automatic sell signal. However, the success of
an actively managed fund can be influenced enormously by its portfolio manager,
who is usually a stock picker and market timer rolled into one. When the
manager changes, the fund family often tries hard to put a positive spin
on the change. As a shareholder, you should learn all you can about the
new manager's style, philosophy and record. If this represents a major change
and you have been satisfied with the fund in the past, this may be a time
to sell that fund.
Usually, a change in manager won't be enough to justify selling a fund.
But if other factors on this list have made you think you should sell, the
change of manager could be enough to tip the scales in favor of bailing
out.
Reason 7: Consider selling a fund (or part of your holdings)
in order to periodically rebalance your portfolio to achieve the right mix
of equities vs. fixed-income and the right types of funds in each category.
Do this rebalancing every three to 12 months in a tax-deferred account and
at least every two years in a taxable account (in which case each sale will
have tax implications for you). By the way, this periodic rebalancing act
is the perfect time to review all the factors we discuss here.
Which funds should you sell? That will depend mostly on which class
of asset you need to decrease in order to reach the proper balance. This
will often mean selling some shares in the funds that have been superior
performers. You may find this uncomfortable if you think of it as getting
rid of the winners in your portfolio. You may find it easier if you think
of it as locking in some of your profits.
If you have a choice of funds to accomplish your objective, weigh all
the factors on this list, then take the opportunity to unload or lighten
up on the fund or funds that are least suitable for your needs. (If you
can add new money to the account, that can be the most tax-efficient way
to rebalance because you won't generate any capital gains or losses.)
Reason 8: Consider selling a fund if your asset allocation
needs change. This is another variation of Reason 1. If stock market
gyrations cause you grief even when you have and follow a good strategy,
you should reduce your stock holdings. Sell one or more stock funds and
replace them with bond or money-market funds.
As investors get closer to the time when they believe they will need
their money, they typically shift their asset allocation to include more
in fixed-income and less in equities. This is an obvious time to sell one
or more equity funds. This is another good opportunity to weed your portfolio
of the funds that you are least happy with.
Reason 9: Don't consider, just sell a fund when your market
timing discipline gives a sell signal. This point seems almost too obvious
to include on the list, but I've put it here in order to make this list
complete. If you get a sell signal, don't even think about it. Just follow
the discipline.
Like rebalancing, this gives you an opportunity, when you later get
a buy signal, to strengthen your portfolio with whatever appropriate fund
or funds you have the most confidence in.
Reason 10: Consider selling a fund if it becomes so large
that it's difficult or impossible for the manager to do what the fund is
supposed to do. For instance, a small-cap stock fund, by definition,
can't keep pouring money into the same stocks forever. If the fund is successful,
this typically will attract so much money that the manager can't continue
doing whatever it was that made the fund successful. Investing more money
in the same stocks will just drive the prices up and ironically, could turn
the fund into a mid-cap one instead of small-cap.
There's no precise benchmark for measuring this trait, but here's an
example of what to look for. In the third quarter of this year, Fidelity's
large, successful Low-Priced Stock Fund changed its criteria for stocks
it would buy. Previously limited to stocks selling for $25 or less, the
fund announced it would henceforth consider stocks priced up to $35.
Reason 11: Consider selling some (or all) of the shares in
a fund in order to pay your taxes on the gains and dividends from all your
investments. This is a variation of selling when you need the money,
which we'll cover shortly. Don't let taxes be "the tail that wags the
dog" in your investment choices. But if you must raise money to pay
taxes, that's a good time to sell whichever fund in your portfolio does
the poorest job of passing all the tests we are describing here.
Reason 12: Consider selling a fund if you're making a gift
to charity. If you've made a pledge of $5,000 to your favorite charity
and you must lighten your portfolio to make good on that pledge, you have
two choices. You can sell the shares and donate the cash proceeds. Or you
can just donate the shares themselves.
Which choice should you make? If selling the shares would result in
a capital loss, sell them and realize the loss for tax purposes. But in
the more likely case, if you've got a capital gain in the fund, don't sell
your shares. That will just increase your taxes. Instead, donate the shares
directly to the charity. That way you never pay a capital gain on your appreciation,
but you get to deduct the full value of the shares as a charitable contribution.
(If you're dealing with a substantial amount of money, review the ramifications
with your tax advisor before you make your move.)
Reason 13: Consider selling a fund in order to simplify and
consolidate your financial life, especially in an IRA. Some investors
seem to collect funds as if they were stamps to fill a scrapbook. Most people
don't need more than a handful of funds to achieve proper diversification.
In our Ultimate Buy and Hold Strategy, we use nine institutional index funds
to represent nine important asset classes. We believe that is plenty for
proper diversification. Yet, occasionally, I see a portfolio that includes
25 or 30 mutual funds, many of them duplicating each other in terms of asset
coverage. Just as you wouldn't normally invest in four money-market funds,
you don't need half a dozen small-cap value funds. In most cases, one should
be plenty.
And if you have multiple IRA accounts, you could be paying excessive
annual fees, one for each custodian. You may be able to save fees and simplify
your record-keeping by consolidating your IRAs under the umbrella of a single
custodian. Here's another opportunity to weed out the funds that are least
suitable for you and refine your asset allocation.
Reason 14: Consider selling a fund in order to take a loss
for tax purposes. Usually, tax considerations should not be the main
reason behind an investment decision. But if you're already planning to
sell a fund with significant taxable gains and you are holding a fund with
paper losses that is only marginally suitable for you, it might be in your
best interest to take the loss and deploy your funds more productively.
Reason 15: Sell a mutual fund when you need the money.
If you invested for retirement and retirement has arrived, it may be time
to sell. Likewise with college costs, a trip around the world or whatever
your objective was for investing in the first place. By the way, before
you sell investments, consider whether it's to your advantage to borrow
instead. Depending on your tax situation and your ability to repay or restore
the borrowed funds, you could come out ahead by taking a loan instead of
selling a mutual fund.
Reason 16: Consider selling a fund if you can improve your
results in a nearly identical investment. Example: Your emergency funds
are in a money-market deposit account at your bank. You get federal deposit
insurance, but that costs you 1 percentage point or more in return when
compared with a money market fund which has nearly identical characteristics.
This is one of the few times when performance can legitimately drive a selling
decision.
Which fund should
you sell?
Some people like to sell the "dogs"
in their portfolios, the funds with the least performance. Others gravitate
toward selling their winners, in order to take some profits (it feels good!)
and to give the "dogs" time to redeem themselves. Still others
will choose the funds that will give them the least tax impact.
My advice: Look first for sales that will restore your asset
allocation to your desired specifications. Remember, your ultimate investment
results are determined more than anything else by asset allocation. So make
this your first priority. If you still have a choice after that, choose
a fund that will result in the most desirable tax impact, whether that's
a gain or a loss. If the amount of money involved is significant, check,
with your tax advisor before you act.
But what about performance?
Do you wonder what's the No. 1 factor most
people consider when they're choosing a fund to buy? Your first three guesses
should be: performance, performance, performance. And we'd bet that's the
top reason most investors use when they decide which funds to sell. But
I think that's wrong on both counts. Past performance simply is not a reliable
gauge of future performance. If it were, successful investing would be easy.
Let me be blunt: Performance is the wrong reason to buy a fund. And
(with the exceptions noted above in Reasons 4 and 16) it's also the wrong
reason to sell.
The best reason to buy or sell a fund is to implement or improve the
proper asset allocation for your needs. And proper asset allocation will
always include some classes of assets that are woefully underperforming
some benchmark. That's no reason to sell. In fact, it may be a reason to
buy. After all, aren't we supposed to be buying low and selling high? Yet
"buy low, sell high" is easy to say and hard to do. Japan is an
excellent example.
Editor's Note: Paul Merriman is editor of the Fund Exchange, 1200
Westlake Ave., N., Ste. 700, Seattle, WA 98109, 1 year, 12 issues, $125.
Mr. Merriman was just named to Forbes Honor Roll. Bull & Bear readers
may access the Fund Echange newsletter FREE on the Web at www.paulmerriman.com.
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