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6 reasons to sell your mutual fund

Sep 29, 2016 by Dwaipayan Bose | 58 Downloaded
Picture courtesy - PICJUMBO

Investors often have high expectations when investing in stocks or equity mutual funds. Since equity markets are volatile in nature, there are periods of time when your investments are not able to live up to your expectations. When the gap between expectation and performance becomes too wide, investors often sell their mutual funds. Another common reason for retail investors selling their mutual funds is the fear of losses. In a market correction, fund values fall and fear of incremental losses cause investors to exit.

Sometimes rumours of impending fall in the market cause investors to react. Some retail investors used to sell their equity mutual fund units to meet seasonal expenses (e.g. festive shopping) instead of looking for other sources of cash. Some investors sell their mutual funds when they hear about better funds from their advisors or friends. We have discussed several reasons why investors sell their mutual fund units. None of these reasons, in our opinion, is good enough to sell your mutual funds, since it can harm your long term financial reasons. However, we are also not saying that, you should never sell your mutual funds. In this post, we will discuss 6 reasons to sell your mutual funds.

Underperformance versus market benchmark

Every mutual fund scheme has a benchmark which the fund manager aims to beat. Please note that, the fund manager does not expect to beat the benchmark every day, but over a period of time. If the fund manager is not able to beat the benchmark over a sufficiently long period (3 years or more), then it does raise a red flag about the scheme’s performance. Even if a fund beats the benchmark over say the last three years, it is important that you see if the fund has consistently beaten the benchmark over various periods in its history. Consistency of a fund’s performance is important, because depending on the market conditions, it can have an impact on your final returns. Trailing returns tells us about the fund’s performance over the trailing returns period, but it does not tell us about the performance consistency. In our blog, we have repeatedly stated that, rolling returns is best measure of a fund’s performance. You can see the rolling returns of any mutual fund scheme relative to its benchmark in our tool, Rolling Return vs Benchmark. We urge investors and financial advisors unfamiliar with this tool, to use our rolling returns tool, because the rolling returns chart reveals very useful information about the fund’s performance. You should see if the rolling returns of your fund are able beat the benchmark rolling returns most of the times. Rolling returns of top performing mutual funds in India were able to beat benchmark returns more than 90% of the times. If the rolling returns of your fund frequently underperform relative to the benchmark then it is a concern and you should seriously consider switching to better performing funds.

Underperformance versus peers

Outperformance relative to the benchmark is the minimum level of performance that you should expect from your mutual fund. A mutual fund scheme may outperform the benchmark, but may still underperform versus peers. If your mutual fund is consistently underperforming relative to its peers, then you are missing out on opportunity to get higher returns. We would like to stress that, when you evaluate the performance of a mutual fund scheme, you should not base your evaluation on short term performance. There are a variety of factors (market related) that can impact short term performance, but have no bearing on long term performance. You should evaluate the performance of a mutual fund scheme over at least 3 year periods. Quartile ranking is a very useful tool to measure the relative performance of mutual fund schemes in any particular category. In this tool, funds are ranked in 4 quartiles (top quartile for best performers, upper middle quartile for the next best above average performers, lower middle quartile for below average performers and bottom quartile for the worst performers). You can use our Mutual Fund Quartile Ranking tool to see the quartile ranking of your fund within the fund category. If your fund is in the two lower quartiles (lower middle quartile and bottom quartile) over a three year plus period, it should raise a red flag. Please note that, we have said red flag and not sell, because we have seen funds bouncing back from the two lower quartiles to upper quartiles. If your fund is in the lower two quartiles, you should see whether the fund was once a good performer and was relegated to lower quartiles due to market conditions relative to investment strategy, or if it has languishing in the lower quartiles for some time. You can use our Top Consistent Mutual Fund Performer tool to see the quartile ranking of your fund for the last 5 years. If your fund has spent the last 5 years, mostly languishing in the lower quartiles, then it is a concern and you should seriously consider switching to better performing funds. What if the quartile ranking track record of your fund is mixed (some times in the lower quartiles and some times in the upper quartiles)? You see if the fund is on an improvement trajectory. You should also use our Rolling Return vs Category tool to see if the rolling returns of the fund versus the category is trending in the right direction. In the same tool, you may also want to compare the rolling returns of the fund, with top performing funds (which you can get from Mutual Fund Quartile Ranking or Top Consistent Mutual Fund Performer tools). You can then take a decision as per your evaluation.

Changes in Fund Strategy

Investors want a particular risk / return profile for their investments, in line with their risk tolerance and investment objectives. Changes in fund investment strategy can have an impact on its risk / return characteristics of the fund. Investors should understand that, investment mandates of most diversified equity mutual funds schemes are broad enough to accommodate a range of risk / return characteristics for the scheme. However, changes to investment strategy (despite being within the mandate) and consequent changes to risk / return profile of a fund will have an impact on your investment objectives. How will you know, if the risk / return profile of your mutual fund has changed significantly since you have invested? Rolling returns, as discussed earlier, not only reveal very useful information on the fund’s performance, they also can provide useful clues to the investment strategy of the fund. If the rolling returns of a fund are diverging away from the benchmark returns over a period of time, it is possible that the risk / return characteristics of the fund may have changed. While you may be happier with higher returns, you should research what is causing the divergence. Is your fund manager taking more risks? Look at the change in percentages of large cap versus midcap in your fund’s portfolio. Is your fund manager increasing exposure to midcaps? Look at sector allocations of your fund. Is your fund manager taking bigger bets in a particular cyclical sector or sectors? These strategies can yield higher returns in the short term, but it changes the risk / return profile of your investment. You can find portfolio details of a mutual scheme using our Mutual Fund Selector tool. In the fund details page (that can be reached using our Mutual Fund Selector tool), you can see the Beta of a fund. If the beta of a fund is increasing over time, then risk characteristic of the fund is changing (increasing). If the risk / return profile of a fund is not aligned with your investment needs, then you have to re-evaluate your investment.

Changes in Fund Manager

In mutual fund investments you are essentially relying on the fund manager to give you the desired returns. A fund house is like any other organization and from time to time, changes in fund management resources are possible. A fund manager may move to a different role within the organization or in sister organizations. Mergers and acquisitions in the mutual fund industry can also lead to fund management changes. Whatever the reason, if slump in a fund’s performance is observed after changes in key personnel involved in the fund, then investors and financial advisors should look into the long term track record of the new fund manager. A temporary blip may be due to a change in investment strategy and approach of the new fund manager. If the new fund manager has a good long term track record, then knee jerk reaction is unwarranted and investors should be patient. However, it has been observed in the past that, changes in fund management personnel have led to prolonged downturns in relative performance. In that scenario, investors should re-evaluate their investment decisions.

Changes in asset allocation profile of the investor

The risk tolerance and asset allocation profile of an investor change over time. As we age, our risk profile and, as a consequence, asset allocation profile, also changes (please see our post, Asset Allocation strategies for different age groups). If your risk tolerance and asset allocation profile changes, you should shift from one risk category to a different risk category (e.g. if your risk tolerance reduces over time, as it should in most cases, you should progressively shift from higher risk investments like midcap funds to lower risk investments like balanced funds to debt oriented funds). Also, investors have a variety of financial goals in their lifetimes. As you approach each goal, you should shift from a riskier investment to a low risk investment, so that you are not by market volatility when you need the money.

You need the money for your goals

Investing should always be goal based. If your investment is not goal based, then you do not know, how much to invest and where to invest. In goal based investing, you reach a point of time, when you need the money for your financial goals, e.g. Retirement, Children’s education, Children’s marriage, House purchase etc. When you need the money for your goals, you will sell / redeem your mutual fund units. However, there are times, when are in need of cash for our regular or seasonal or unexpected one-off expenses, not related to our mutual fund investment goals. It is not prudent to liquidate equity fund investments, earmarked for long term goals for your short term liquidity needs. For your shorter term liquidity needs or to meet unexpected one-off expenses, you should have sufficient liquid funds. If for whatever reason, liquid funds are not sufficient, then you should have a menu card of options, ranging from short term debt funds, income funds, debt oriented hybrid funds, balanced funds and equity funds, with equity funds, last in the pecking order. For your longer term financial objectives equity funds are the best investment options; however, as discussed earlier, once you start approaching the goal (2 to 3 years prior to the goal time-line), you should switch to lower risk investment options.

Conclusion

As discussed at the start of this post, investors sell mutual funds, when they are not able to meet the investor’s expectations. Investors should have realistic expectations; if you are expecting 30 – 40% returns every year, then you are likely to be disappointed. Investors should also understand that, mutual funds are market linked investments; or in other words, they are subject to market risks. Therefore, if you expect your mutual fund to give 20% return, when the market has fallen 10 – 15%, you are being unrealistic. It is very important to have rational expectations in mutual fund investments. If you have rational expectations and good fund selection capabilities, you are likely to be happily surprised on the upside. At the same time, you should be prepared to take actions, if your investment is underperforming on a variety of parameters that we have discussed in this blog post. Finally, keep your asset allocation and investment goals in mind, and make appropriate investment decisions.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development

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