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 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, 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 by 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. (See How to Select the Best Mutual Funds.) 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 your 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 managers 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. As we showed in some detail in How to Select the Best Mutual Funds, 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, as we see in the following response to a question from a reader.

Q. I notice my buy-and-hold worldwide equity portfolio includes some funds that invest in Japan. Why do you have me in that market when it’s so obvious that Japan has serious financial problems?

A. That is an excellent question that relates to asset allocation. Let me ask you something: If I designed a portfolio for you that deliberately and arbitrarily excluded 14 percent of the world equity market, would you believe you were getting a truly diversified worldwide portfolio? I doubt it. And yet that’s what would happen if you had no Japanese investments in your portfolio.

If you don’t believe in the concept of buying low and selling high, it’s going to be hard to know what you should do instead. But if you do believe in that concept, then you have to be willing to take opportunities to buy assets when their prices are low. Yet when prices are declining and nobody seems to want that asset, it takes a strong leap of faith to buy.

Japan gives us a great lesson in how difficult it is to predict the future. You probably remember eight years ago, in 1989, when Japan’s economy was leading the whole world. The Japanese were buying U.S. companies, U.S. bonds and U.S. real estate. Heck, they even bought Rockefeller Center in New York City, and some people were afraid they were going to buy the whole country. But now, Japan’s own commercial real estate has declined 70 percent. Its stock market has declined more than 60 percent. This may not be the bottom of the market, but investors who spurn Japan today are betting that there’s simply no future in companies like Sony, Toyota, Mitsubishi and Honda. That is not a bet I would want to make, and the point isn’t about predicting the future of specific companies or even specific economies.

As experienced investors know, there’s always a market or a stock or an asset class that looks like "an obvious sure thing." That’s what the Japanese market looked like in the late 1980s, and that’s what the U.S. stock market looks like now. The U.S. market won’t always be king, just as Japan’s reign was cut short. But from an asset allocation standpoint, if history is any guide someday in the future we’ll look back at today and see it was a good time to snap up bargains in Japanese securities – and also a good time to lighten up on U.S. securities. Re-balancing your portfolio is a good idea. And it’s why some of your assets should be allocated to Japanese equity funds.

 

 

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