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Eight Reasons to Dump a Mutual Fund

Many financial advisors and academics do not advise selling stocks and mutual funds when prices are dropping during bear markets. If you can just hold on from side to side thick and thin, they argue, you are likely to enjoy returns better than any other asset class over the long run.

Though, there are occasions when selling a mutual fund might be acceptable. Buy and hold is not everlastingly. Here we glance at the top eight reasons for selling a mutual fund.

1. Portfolio Rebalancing

Over time, trends in financial markets may cause asset allocations to diverge from desired settings. In other words, some mutual funds can nurture to a large proportion of the portfolio while others shrink to a smaller proportion, exposing you to a different level of risk.

To avoid these possibilities, the portfolio can be rebalanced periodically by selling units in funds that have relatively large weights and transferring the proceeds to funds that have relatively small weights. Under this rule, the time to sell equity mutual funds is when they have enjoyed high-quality gains over an extended bull market and the percentage allocated to them has drifted up too high.

2. Mutual Fund Changes or Mismanagement

Mutual funds might change in a many number of ways that can be at odds with your original reasons for buying. For an instance, a star portfolio manager could jump ship and be replaced by someone missing the same capabilities. Or there may be approach drift, which arises when a manager gradually alters his or her investing approach over time. (For more insight, check out Focus Pocus May Not Lead to Magical Returns and Must You Follow Your Fund Manager?)

Other signals to move on include an increasing trend in annual management expense ratios (MERs) or a fund that has developed large relative to the market. If the fund has developed large compared to the market, managers could have difficulty differentiating their portfolios from the market in order to earn above-market returns.

3. Investor Growth

As you gain more and more experience and you can acquire more and more wealth and hence you may outgrow mutual funds. With larger wealth comes the ability to buy enough individual stocks to achieve adequate diversification and avoid MERs. And with superior knowledge comes the confidence to do it yourself, whether it is actively picking stocks or buying and holding market indexes through exchange-traded funds (ETFs).

4. Life Cycle Changes

Although stocks historically have been the best investments to own over the long run, their instability makes them untrustworthy vehicles in the short term. While retirement, children's post-secondary educations, or some other funding requirements approach, a good idea is to shift out of stock-market funds into assets that have more certain returns, such as bonds or term deposits, whose maturities coincide with the time that the funds will be needed.

5. Mistakes

Every now and then, investors' due diligence is incomplete and they end up owning funds they otherwise would have not purchased. For an instance, the investor might discover that the fund is too impulsive for their tastes, a closet-index fund with a high MER, or invested in undesirable securities.

Portfolio errors might also have been dedicated by the investor. A frequent mistake is over-diversifying with too many funds, which can be difficult to keep tabs on and can tend to average out to market performance (less fund fees).

Another common misstep is to puzzle owning a large number of funds with diversification. A large number of funds will not smooth out fluctuations if they tend to move in the same direction. What's desirable is a collection of funds, of which some can be expected to be up when others are down.

6. Valuation

Shift out of mutual funds to rebalance your fixed portfolio allocations by using a stretchy or opportunistic approach. A common valuation benchmark is the price-earnings ratio (P/E ratio); for U.S. stocks, it has averaged 14 to 15 over time, so if it rises to 24 to 26, valuations are overextended and the risk of a downturn is prominent.

7. Something Better Comes Along

Selling on every occasion something better came along. In the mutual fund territory, some funds can come onto the market with innovations that are better at doing what your fund is doing. Or, over time, it may become obvious other portfolio managers are performing better against the same benchmarks.

8. Tax Reduction

Mutual funds held in taxable accounts might be down significantly from their purchase price. They can be sold to understand capital losses that are used to offset taxable capital gains and thus lower taxes.

If the sale was exclusively to realize a capital loss for taxation purposes, the investor will want to re-establish the position after the 30-day period necessary to avoid the superficial-loss rule. The investor might take a possibility that the price will be the same, lower or might choose to hold a proxy for the fund's price movement.

Tax-loss selling tends to take place during August to late December. That's also the era when many funds have anticipated the capital gains and income they will be distributing to investors at year end. These amounts are taxable in the hands of the investor, so a supplementary reason to sell a losing fund from the tax point of view may be to avoid a large year-end distribution that would entail paying additional taxes.

Mutual Funds
Mutual Funds