Mutual funds seem like the perfect vehicle for buy-and-hold investors. After all, the fund is entrusted with the job of trading stocks and bonds for you. But a buy-and-hold strategy doesn’t work in every situation, and sometimes selling a fund is a smarter move than hanging on long term.
“Overall, I’m a buy-and-hold type of advisor,” says Cathy Gearig, a wealth advisor with LifePlan Financial Advisory Group in Rochester Hills, Michigan. “But that doesn’t mean you keep stuff that doesn’t make sense.”
With stocks, the case for selling is usually clear-cut, based on a company’s future earnings prospects, current valuation and ability to navigate the business challenges that lie ahead. A mutual fund, though, requires a different set of markers.
[See: 8 Times When You Should Sell a Stock.]
There’s a major change with the fund. Sometimes a new portfolio manager or a change in the fund’s investment strategy or benchmark can take a fund in a different direction. “A change in management doesn’t always mean you need to sell, especially if it’s being taken over by a co-manager who is coming up through the ranks,” but if it’s a completely new team, consider what that means for you, Gearig says. Any shift in the mix of stocks and bonds should still fit within your asset allocation, she says.
The fund consistently underperforms. Mutual funds can be compared to their peers and to the benchmark the fund aims to match or beat. Check the fund’s track record over one, three and five years to see how the fund has done. “If a fund has sustained consistent underperformance — not just for six months or one year but for a longer period of time — it probably makes sense to sell,” Gearig says.
Even then, Gearig cautions there may be justifications for hanging on at least temporarily. “I’m more reluctant to sell something if it’s going to create a taxable event,” Gearig says. A struggling fund that you’ve held for many years may have long-term gains that become taxable once you sell. If so, you may want to consider the next reason for dumping a fund.
You need to harvest losses. If you can offset capital gains in one mutual fund with losses from selling another, it may make sense to sell. The practice of offsetting investing gains with losses to minimize what you’ll owe Uncle Sam is called tax-loss harvesting.
Here’s how it works. A mutual fund purchased at $10 a share that now trades at $8 a share can be sold for a $2 loss. That can then offset a $2-per-share gain from another mutual fund.
Selling in that instance may improve your after-tax return, says Adam Reinking, partner at AdvicePeriod in Austin, Texas. “Taxes are something you can control,” Reinking says. “If you know when you are going to sell something, you might want to sell a mutual fund at a gain and something else at a loss, so you don’t have the tax liability in your portfolio.”
When harvesting losses, you should consider the timing of the sale, your potential tax brackets for both federal and state, and whether you have long- or short-term capital gains, which are taxed at different rates. “If you’ve had the investment longer than a year, it can make a difference because the taxes on the gains could be significantly less than if the investment were held less than or equal to one year,” says Mathew Dahlberg, founder of Main Street Investments in Kansas City, Missouri.
[Read: Mutual Funds Are the Key to Millennials’ Retirement.]
There’s a high expense ratio. In an era of low-cost index and exchange-traded funds, it can be hard to justify a fund that charges a hefty fee. With expense ratios, Gearig suggests staying below 0.25 percent for passive funds and aiming for around 0.8 percent for actively managed funds. In 2016, the average expense ratio for actively managed funds was 0.82 percent, according to the Investment Company Institute.
Gearig likes two actively managed funds: Yacktman Fund Class 1 (ticker: YACKX), which has a 0.76 percent expense ratio and targets big value companies, and Fidelity Low-Priced Stock ( FLPSX), a specialty fund, with an expense ratio of 0.88 percent, that seeks out mid-cap value companies. “You are going to pay something for it, but they have a proven track record,” she says.
She also likes Dimensional Fund Advisors U.S. Core Equity 1 ( DFEOX) for its broad stock exposure and low expense ratio of 0.19 percent but cautions it can only be purchased through an advisor.
[See: 8 Things Not to Hide From Your Investment Professional.]
The fund has a back-end load. Some mutual funds are put into an A, B or C share class, each with its own load fees. “If you have a mutual fund with any type of load on it, fire anyone who sold it to you,” Reinking says, because they’re more expensive than no-load funds. A shares have a front-end load, which are extra fees and commissions that are added into the purchase price of those shares. C shares have level loads that are spread out evenly over the time they’re owned but typically a higher expense ratio of more than 1 percent, Reinking says.
Back-end loaded B class shares charge investors an exit fee when the fund is sold. Those charges can range from 4 to 7 percent, Reinking says, based on a sliding scale for the number of years an investor has owned the shares. The longer you’ve owned them, the less you pay until eventually the fee becomes zero.
This makes the decision to sell such funds more complicated, as the sliding scale of fees must be factored in. For example, say you own a mutual fund that has 1.5 percent annual expenses while a similar fund only costs 0.5 percent per year. If both funds were no-load, selling the shares and buying the cheaper fund should save 1 percent in fees annually.
But if the fund charges a 4 percent back-end load, an investor must decide whether to pay a 4 percent fee to exit — four times more than the annual savings for switching funds. If an investor has to wait seven more years for the back-end load to expire and hit zero, “I’m better off getting out now and taking a 4 percent haircut than paying an extra 1 percent for seven years,” Reinking says.
To find the sweet spot of when to sell or hold, Reinking suggests asking three questions: What are the fees today, how much will you save by investing in a lower-cost investment now, and how many more years do you have before the back-end load expires completely?
You have substantial gains. As with stocks, mutual funds with large gains can throw a portfolio out of balance. Taking those gains to restore a portfolio’s original allocations is a good idea.
A fund with substantial gains also is likely to sell for a much higher share price than when you first bought. Although that alone isn’t reason to sell, it might be if the fund has reached an investor’s pre-defined price target, says Justin Kumar, a senior portfolio manager with Arlington Capital Management in Arlington Heights, Illinois. Kumar suggests setting a price target for a mutual fund based on your risk tolerance and the percentage gain you hope to get. Once the target is reached, you sell the shares. It’s an impartial way to determine when to sell.
[See: 13 Ways to Take the Emotions Out of Investing.]
“Unfortunately, the average investor, who can be emotional and motivated by greed and fear, oftentimes does not sell when he or she should,” Kumar says. “In fact, studies show that the average investor is more likely to buy when he or she should be selling.”
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When Should You Sell a Mutual Fund? originally appeared on usnews.com
