5 Reasons to Sell a Mutual Fund
By Ron DeLegge, Editor
November 30, 2009
SAN DIEGO (ETFguide.com) Ė Advice about which mutual funds to buy is abundantly available from blogs, the financial media, mutual fund sales people along with friends or family. On the other hand, advice about when to get rid of a mutual fund is less abundant.
Even though most mutual funds are meant to be bought and held, there are exceptions to the rule. How can you know when itís time to sell your funds?
Consistent Market Underperformance
If you own a stock or bond mutual fund thatís consistently underperformed its corresponding index over various market cycles, itís a sure sign youíve invested in a dud. And guess what? The only thing worse than buying an investment flop is holding on to it. Before you can find out if you own a mutual fund dud, you must first use the correct point of performance comparison.
The mutual fund industry often resorts to comparing its funds to non-corresponding benchmarks, peer groups or other useless points of reference. Besides distracting fund investors with a lot of noise, this serves a secondary purpose of masking the true performance of mutual funds. ďPeer group comparisons are dangerous,Ē states Nobel Prize winning economist, William F. Sharpe. Just because your mutual fund is outperforming its peer group doesnít necessarily mean its outperforming its corresponding benchmark index.
Sharpe makes a better suggestion: ďThe best way to measure a manager's performance is to compare his or her return with that of a comparable passive alternative.Ē
Hereís one example of how you do that: If you own small cap funds, start comparing their historical performance versus ETFs following key small cap benchmarks like the Russell 2000 (NYSEArca: IWM), S&P Small Cap 600 (NYSEArca: IJR) and the MSCI US Small Cap 1750 Index (NYSEArca: VB). Always compare apples to apples and always compare performance over identical time frames.
Whenever your mutual fund fees go up, take notice. This is particularly true for bond and money market funds, where the long-term performance returns compared to stock funds tend to be smaller. Rising fees confiscate a greater portion of both your returns and income. What can you do to fight back?
ďYou should be alert to new low-cost opportunities that may emerge as the industry becomes more price competitive,Ē states John Bogle, author and retired founder of the Vanguard Group.
Mutual fund investors are often convinced to invest in particular funds based upon the reputation of the fund manager running them. Unfortunately, the people managing these funds arenít working for them with a long-term view. Thatís because the typical mutual fund manager doesnít keep the same job for a period longer than 5 or 6 years. Isnít it strange irony fund companies preach long-term investing to the public, yet the job turnover rate of managers at some of these same companies would rival a fast food restaurant?
Fund companies try to put a positive public spin on manager changes, but donít bite. Manager changes are disruptive and can lead to a wave of other unexpected changes like massive turnover of portfolio holdings. Itís not uncommon to find newly hired fund managers trying to undo the work of old managers! Meanwhile, your money is held hostage to experimental investment strategies. Understanding these potholes will help you to have a realistic view of your mutual fund investments.
If you plan on owning a mutual fund for 30 years, youíll probably have 5 to 6 different individuals managing your fund. If youíre not ready for that type of ongoing disruption, stick with index funds and index ETFs for the foundation of your investment portfolio.
Changing Investment Policies
A change in a mutual fundís investment objective or policies is another tell-tale sign it might be time to bail. Often, the changes are not announced by the fund company, but can be uncovered by evaluating your mutual fundís holdings.
For example, if youíve chosen to invest in a U.S. large cap stock mutual fund that suddenly begins investing in international or smaller company stocks, it should immediately raise red flags. What if you ordered lentil soup in a restaurant, but were served pizza and then subsequently billed for hamburgers? If you would never think of eating this way, then why would you invest this way?
You should treat fund managers that deviate from your fundís stated investment objective as untrustworthy. They are probably subjecting you and other shareholders to a host of unknown risks.
Other Radical Changes
There are other radical changes that should make all mutual fund investors unsettled. If your mutual fund suddenly changes its name, merges with another mutual fund or if your fund company gets absorbed into a new fund management company, beware. More often than not, dramatic changes are disruptive and counterproductive to your fundís performance.
From 2003-04, the mutual fund industry experienced a massive late trading scandal thatís been buried by todayís news. Fund companies that previously had sterling reputations like AIM Advisors, Alliance Capital, Invesco, Janus Capital, Nations Funds (Bank of America), Prudential Securities, Putnam Funds, Strong Funds and others were engulfed in the scandal. If the disciplinary history of your mutual fund company turns from pristine to dirty, it could be another sell signal.
One last reason to sell your mutual fund, which Iíll add as a bonus, is if the investment objectives of your fund no longer match your investment goals. It makes little sense to continue owning funds that no longer meet your financial needs.