When Is The Right Time To Sell Mutual Funds?

As investors, the most challenging task isn’t just selecting the right fund but also knowing when to sell them judiciously. This report highlights the various factors that investors must consider to be able to make maximum profit out of their funds or at times exit before it is too late. [EasyDNNnews:PaidContentStart]

Imagine this scenario: You have diligently crafted your mutual fund portfolio, aligning each investment with your financial objectives and risk tolerance. All seems well until one day the market takes a steep dive, injecting uncertainty into your investment journey. A question arises: Do you ride out the turbulence or cut your losses by selling? Conversely, picture yourself at the opposite end of the spectrum: you embarked on your investment journey four years ago. Encouraged by the initial growth in your mutual fund portfolio, you now ponder, “Should I cash out some or all of my holdings?” 

These are the dilemmas that every mutual fund investor confronts at some point. Investors typically cite three reasons for considering selling off a fund investment: profit, loss or stagnation. Some may argue, “My investments have surged, so isn’t it time to secure profits?” Others may question, “This fund has experienced recent losses, should I bail out?” And then there are those who wonder, “The fund hasn’t seen any significant gains or losses, so perhaps it’s time to sell.” These impulses often stem from a bias for action, prompting investors to seek justification for making a move in any scenario. 

Without a doubt, none of the aforementioned reasons are valid grounds for selling a mutual fund. Each rationale lacks merit on its own and may lead investors astray. Take, for instance, the notion of booking short-term profits—a concept that has long been discouraged in mutual fund investing. It’s generally unwise to cash out of mutual funds until you have achieved your investment goals. Many investors mistakenly view mutual funds, especially equity mutual funds, as akin to individual stocks. However, they are as distinct as chalk and cheese. While shares represent single entities, an equity mutual fund comprises a diversified portfolio of various company shares. 

These two investment vehicles exhibit different behaviours and possess varying risk-return profiles. Investing in individual stocks is like crafting a single dish—requiring precision, expertise and carrying higher risk if things don’t pan out as anticipated. On the other hand, an equity mutual fund portfolio resembles a lavish buffet spread—providing diversification, mitigating risk and fostering a more balanced investment strategy. Just as a chef meticulously selects dishes to please guests, retail investors lacking the time or expertise to construct portfolios can opt for mutual funds to pursue their financial objectives while minimising risk. 

Know When to Sell 

Evaluating Performance Weakness
While a single year of underperformance in your mutual fund may not raise immediate concerns, sustained underperformance over two to three years can become frustrating. Before deciding to sell a fund, it’s crucial to ensure that you are comparing its performance to an appropriate benchmark. Assess whether the fund’s underperformance is a recent occurrence or part of a persistent trend. For instance, consider the case of the Aditya Birla SL Small-Cap Fund (G), which boasted a one-year return of 50.65 per cent ending April 9, 2024. While this figure may seem impressive at first glance, comparing it to the benchmark reveals a significant underperformance. During the same period, the benchmark surged by 65 per cent, indicating a notable lag. 

Additionally, when compared to its peers in the category, which averaged a return of 56.4 per cent, the fund fell short. Among approximately 27 small-cap funds, this particular fund ranked 22nd in terms of performance, indicating a lacklustre accomplishment within its category. Expanding the evaluation to a longer timeframe, over a five-year period, the fund delivered an annualised return of around 17 per cent, placing it in the fourth quartile within its category. If you find yourself holding a fund that consistently underperforms in both the short and long term, while also lagging behind its category and benchmark, it’s essential to conduct a thorough investigation into the reasons behind its poor performance. 

Take the time to analyse whether the fund is simply experiencing a temporary setback in its investment style or if there are deeper underlying issues. It’s not uncommon for investors to hastily exit struggling funds, only to witness a rebound in performance shortly afterward. Verify if the fund manager is still adhering to the same investment strategy that previously led to success. Additionally, consider any significant changes at the fund-company level, such as mergers or a sudden influx of assets, which could impact performance. 

Interestingly, strong outperformance can sometimes be a cause for concern as well. Excessive gains may indicate that the fund is taking significant risks to achieve those returns. For example, if an intermediate-term bond fund is consistently returning more than expected, it might be assuming higher levels of risk than desired. Conduct a thorough analysis to understand the source of these outsized returns and assess whether they pose any potential risks. Ultimately, it’s important not to make hasty decisions based solely on short-term performance without conducting a comprehensive analysis. 

Change of Fund Manager
The effectiveness of actively managed mutual funds hinges largely on the expertise and performance of their fund managers and analysts. When a fund manager departs, investors often question whether they should sell their holdings. The decision is not straightforward and depends on various factors. While fund houses definitely downplay the significance of a managerial change, citing robust procedures to ensure continuity, it’s prudent to approach such transitions with scepticism. Assessing the potential impact of a management change involves several considerations. 

First, evaluate whether the departing manager operated independently or as part of a team, and examine the level of analyst support available to the incoming manager. Scrutinise the incoming manager’s experience, particularly their track record of managing other mutual funds. If the replacement has a proven track record at a similar fund, it instils confidence in their capabilities. However, if the new manager lacks a substantial record, examine the performance of other funds in the same asset class within the firm. Some fund houses possess deep talent pools and can seamlessly replace departing managers, while others may struggle across multiple funds in the same asset class. 

We have ample examples in our mutual fund industry where a change in management has led to improvement in the performance of the fund. For example, the funds managed by Religare Invesco Asset Management saw substantial improvement after Invesco acquired its partner’s share in Religare Invesco Mutual Fund and renamed the fund as Invesco Mutual Fund in 2016. Invesco India Large-Cap and Mid-Cap Fund, a fund from this house, was in top quartile in terms of performance for three continuous years after this. Before 2017, it used to be in the second quartile and hence there was a jump in the performance. 

Certain types of funds are less affected by managerial changes than others. For instance, index funds, which replicate a benchmark, are less impacted by such shifts or transitions as they do not involve active stock selection. However, for actively managed funds, where managers actively select stocks, managerial changes carry more significance. Investigate whether the incoming manager plans to implement a new strategy. Even if they have a successful track record with the proposed approach, a strategy shift may render the fund incompatible with your investment objectives. It’s essential to recognise that funds are not like individual stocks, and a managerial change won’t immediately impact the fund’s value. Take the time to thoroughly research and evaluate whether a change is warranted before making any decisions. 

Assessing Strategy Changes
A shift in strategy can often be more worrisome than a change in manager. It may suggest that a previously successful portfolio manager has lost faith in their approach. In the worst case scenario, frequent strategy changes could indicate that a fund lacks a well-defined strategy, and the manager is simply trying to adapt to the current market trends. The issue with managers who chase trends is that they tend to be late to the party and often miss out on potential gains. To outperform the market, you need a fund that sticks to its strategy even when it’s not the most popular choice. Sometimes, managers are forced to change strategies due to rapid asset growth. 

For example, the manager of a small-cap fund may be compelled to start buying large-cap stocks, or increase the number of stocks in the portfolio. Regardless of the reason, changes in strategy can result in a fund that no longer aligns with your investment goals. If you originally invested in a small-value fund for exposure to small-value stocks but the manager starts buying large-value stocks, you may end up with an unintended mix of styles in your portfolio. In such cases, you might need to sell one of your large-value funds and find another small-value fund to maintain your desired style balance. However, it’s important to be cautious when defining a change in style. 

Impact of a Managerial Change in Fund Performance 

There is a great deal of empirical evidence that suggests that active fund managers cannot produce alpha. However, these results are generally based upon fund data, rather than on the performance of an individual fund manager. In other words, calculating alpha using 10 years of monthly return data associated with a single mutual fund often leads one to the conclusion that the alpha is both economically and statistically indistinguishable from change in fund manager. So, any investor that had invested in an actively managed fund would probably have been better off investing in a passive equity mutual fund. 

The related conclusion with regard to this result is that the manager responsible for managing the fund did not demonstrate any investment skill. But over 10 years the fund may have had more than one manager. Any one of these managers might have had investment skill but, when averaged over time with one or more managers that did not have the requisite skill, the impression is that all fund managers do not have any active investment skill worth paying for. 

However, it is possible that there are managers with skill, but that these managers may move frequently as they are poached by other fund management groups, taking their skill with them – skill that is lost when viewed at the fund level. According to a study conducted by Andrew Clarea, Nick Motsona, Svetlana Sapuricb and Natasa Todorovic in their paper titled ‘What Impact Does a Change of Fund Manager Have on Mutual Fund Performance?’, compelling evidence indicates that a managerial change can indeed lead to a significant positive impact on benchmarkadjusted fund returns. 

They uncovered evidence of a notable decline in the benchmark-adjusted returns of funds that were top performers before the manager’s exit. Conversely, there is a substantial improvement in the average benchmark-adjusted returns of funds that previously underperformed before the manager’s exit. These findings suggest that the UK fund management firms have demonstrated relative success in replacing underperforming managers with more competent ones. 

However, they have struggled to find equivalent replacements for their top-performing managers. The main result in their paper is the finding of very strong evidence to suggest that a managerial change does have a significant positive impact on benchmark-adjusted fund returns. 

Rising Expense Ratios
One key predictor of mutual fund returns is the expense ratio. Therefore, if a fund hikes its costs significantly, it raises a major red flag. If you observe that any of your funds’ expenses have surged well above the peer average, it’s a signal to delve deeper. While you may want to allow small company and international stock funds a bit more flexibility, expenses exceeding 2.5 per cent should certainly raise concerns for direct plans. If you notice a spike in your fund’s expense ratio, scrutinise its asset base. Has it declined recently? Many funds implement breakpoints, where expenses fluctuate based on asset levels. Thus, if your fund has experienced significant outflows, this could explain the rise in expenses. 

You may still opt to exit the fund, but at least you have a valid reason for the uptick in costs. However, if the expense ratio climbs but the fund continues to outperform a given benchmark over a specific period, it may not necessarily be cause for worry. A higher expense ratio can contribute to better returns, so there’s no need to fret over a larger expense ratio if it is justified by such a performance. If neither a performance fee nor asset outflows account for the increase in your fund’s expense ratio, it becomes a cause for concern—especially if the hike surpasses the costs of similar offerings in the same category. This could imply that the fund’s board has failed to prioritise shareholders’ interests during negotiations with the management company. In such cases, it may be prudent to explore other fund options. 

Keeping Tabs on Asset Growth
One common observation is that with the expansion of funds in size, their returns often start to stagnate, burdened by their hefty assets. They lose their agility, and their performance begins to align with the average for their category. This phenomenon, often referred to as asset bloat, occurs because the manager of a growing fund must invest in more stocks, larger companies, or both. If the fund’s past success relied on investing in smaller-cap stocks or maintaining heavy exposure to top holdings, its performance could falter as the manager is compelled to manage the fund more similarly to competing offerings. 

Moreover, a fund with a rapidly growing asset base may trade less frequently due to its impact on stock prices. With a substantial amount of capital to invest in a single stock, the buying activity can drive up its price by disrupting the supplydemand balance—resulting in more investors vying for shares of that stock. As a result, it may be challenging for the manager to acquire all the desired shares at once, leading to significant cost disparities between the first and last shares purchased. 

Consequently, the growing fund can create its own obstacles, hindering performance through excessive trading. To mitigate the adverse effects of asset bloat, many funds, particularly those focusing on small-cap and mid-cap stocks, have implemented measures such as halting lump sum investments from new investors or imposing limitations on new systematic investment plans (SIPs) when their assets reach a certain threshold. Even if your fund’s performance hasn’t shown signs of slowing down, it’s prudent to remain vigilant about how asset growth could impact its strategy and its role within your portfolio. 

Evaluating Your Needs 
As your financial objectives evolve, so should your investment strategy. For instance, let’s say you initially invest in a balanced fund, which allocates funds to both stocks and bonds, with the intention of saving for a house purchase within the next five years. However, if you later marry someone who already owns a house, you may opt to redirect those funds towards retirement planning instead. In this scenario, you might choose to sell the balanced fund and transition to a portfolio consisting primarily of equity funds, aligning your investments with your revised goal and the new timeline until you plan to access your funds. 

Similarly, as you approach your financial goal, it’s prudent to adjust your investment allocation accordingly. For instance, Debt Funds may become increasingly prominent in your portfolio as you near your goal, providing a more conservative approach to wealth accumulation and safeguarding your capital as you move closer to your target. Therefore, given the changing nature of your aspirations and the related needs to save enough funds, the objectives must determine the financial journey of your mutual funds. Some investors may opt for aggressive investing if the goals are short-term in nature while others may choose a more passive and risk-tolerant approach. 

Exiting Wisely 
Selling a mutual fund shouldn’t be a snap decision. However, there are valid reasons to consider it. Perhaps your portfolio needs rebalancing to maintain your desired asset allocation. Maybe the fund’s investment strategy has shifted significantly from its original focus. It’s also okay to admit that you initially misunderstood the fund’s approach. Of course, your own investment goals may have evolved, making the fund no longer suitable. Tax considerations can also play a role with potential tax write-offs for selling a fund at a loss. Finally, if the fund’s volatility is causing you undue stress, it might be wise to explore more stable options that better align with your risk tolerance. Carefully weigh these factors before making any final decisions about selling your mutual fund holdings. 
 

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