Examining the yields of a mutual funds or ETFs and selling the ones generating weak returns goes without saying, but knowing when to part with the other ones can be tougher.
Investors need to avoid extolling the original virtues of a fund and consider its current attributes instead, said Paul Jacobs, chief investment officer of wealth manager Palisades Hudson Financial Group, a Scarsdale, N.Y.-based financial planning firm with $1.2 billion under management.
“Ask yourself if you'd buy the fund again today if you were starting over,” he said. “If for any reason the answer is no, then it may make sense to sell. A portfolio is no place to get sentimental.”
These are the top six reasons to move on from a fund or ETF:
The recent selloffs in the market might prompt more investors to sell their funds, because their “unrealized gains are lower or may have turned into unrealized losses,” Jacobs said. This also makes sense if you sold a winner this year also.
“Even if your fund has been performing well relative to the competition, it’s always feels better to sell knowing that you'll get a tax benefit instead of having to take a tax hit,” he said.
Selling a fund only because the sector is “out of favor” or the market has declined can be a drawback, said Jon Ulin, a managing principal of Ulin & Co. Wealth Management in Boca Raton, Fla.
“Don’t let your tax tail ‘wag the dog’ of your long term investment strategy,” he said. “In some cases, an out of favor investment may be your best weapon or market hedge when the tide turns.”
The current market volatility could produce unintended consequences, said Edison Byzyka, vice president of investments for Hefty Wealth Partners in Auburn, Ind.
“This may likely be a smart move but beware of drastic market moves to the upside that can hurt performance,” he said. “At the end of the day, this may another form of market timing.”
Fund Exceeded Expectations
Perhaps the fund has demonstrated “spectacular” short-term performance and has outperformed other funds. That could be a red herring, said Jacobs. Research its holdings and commentaries on the fund’s website and also consult Morningstar’s review, he said.
“This often indicates the fund manager is doing market timing or taking too much risk,” he said. “It’s not so great when the fund tanks.”
Managers who lose their discipline and are not staying true to the fund’s original strategy could also be taking on too little risk. Some managers wind up following the herd, and your fund or ETF winds up being a “closet index fund” which has higher fees, but in actuality the performance mirrors its benchmark index, Jacobs said. Look for a fund which is generating better returns or one with lower fees.
Portfolio Needs Rebalancing
When your fund performs past its expectations, one asset class could be overweighted. It might be the right time to sell a portion of your position in the fund to get your asset allocation back on target, said Jacobs.
If it has been over a year since you rebalanced, now is a good time to do so which means you might have to sell funds which have held up well and purchasing funds that are taking a hit, he said.
“It’s still the right thing to do,” Jacobs said. “Investors who do the opposite and sell funds which have declined so they can buy more of the funds that are on a hot streak wind up in trouble.”
Past Returns Are Misleading
Selecting an ETF or sector merely on its past returns is an example of “insanity,” said Ulin. Be prepared that higher returns often produce a larger amount of volatility, which the market is already exhibiting this year. Consider if your appetite is prepared for more volatility.
“By the time you ‘discover’ a great idea at a cocktail party, it may already be overpriced and running its course,” he said.
Chasing performance means you can wind up on the wrong side of the equation when the fund manager takes a large position which deviates from the norm, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa.
The fund could overweight a certain sector or industry, and if the managers are accurate, big rewards are reaped, he said. “Those funds that placed big bets and won recently are likely to ‘revert to the mean’ and have bets that fail,” he said.
Some funds stray too far from their original benchmarks or “incorporate hedging or options or futures” that investors are not aware of, said Ulin.
“More often than not, top ranked funds end up at the bottom of the barrel the next year,” he said. “Selecting a top performing mutual fund based just exclusively on high returns or number of Morningstar ‘star-ratings’ can get you into hot water over time if you are not implementing a more thorough due diligence.”
Contrarian mindsets often generate better returns such as purchasing sectors which are undervalued but have a “strong upside potential based on trends,” Ulin advises. “This is kind of like buying winter tires in the summer,” he said.
When the expenses of the ETF or fund increase, start examining other options, because you could easily find one with a similar strategy and pay less, which is crucial when you are looking at index funds, said Jacobs.
The competition on annual fees is increasing and many companies are lowering expenses to attract investors.
“Many new index funds charge 0.15% or less and if your index fund charges 0.50% or more annually or the actively managed mutual fund charges 1% or higher, start looking for alternatives,” he said. “If you think you've found a better fund than the one you've been using, now should be a good time to pull the trigger and swap funds.”
If your moderate-allocated portfolio is tracking at “only 3% for the past two years net of management fees, you may not want to sacrifice any more points in expenses,” said Ulin. “Every point you are being wacked in fees can count. In most cases, a higher cost investment may not provide you a higher return than the same strategy with a lower cost investment.”
Portfolio Manager Leaves
Avoid overreacting merely because the fund manager left and examine the strategy first before determining whether you need to shed the asset, said Jacobs. Some new managers will continue the same investment strategy as before.
One caveat to remember is that unlike index funds, active managers are “not handcuffed by specific rules and their prospectus may allow them more leeway to go outside of set style boxes and sector allocations, including utilizing options, futures and derivatives,” said Ulin. “Over the past few years where the global markets have been more volatile and less efficient, it may make sense at times to place a bet on a fund whose manager has succeeded at taking advantage of market inefficiencies.”