Investing in mutual funds can be a great way to grow your wealth, but it's important to remember that exiting your investments is just as important as entering them. While there's plenty of information available on how to pick the right mutual funds to invest in, exit strategies are often overlooked. Having a solid exit strategy can help you make the most of your investments and avoid costly mistakes. It may also be necessary to exit from a mutual fund if it is underperforming compared to its benchmark or its peers. In this article, we'll delve into the crucial topic of exiting mutual funds and discuss the key factors to consider when making this important decision. From investment goals to performance, management changes to new opportunities, we'll explore everything you need to know about exiting your mutual fund investments and creating a strategy that works for you.
Exiting Mutual Funds vs exiting stocks
When it comes to exiting investments, the strategies used for stocks should not be applied to mutual funds as they are fundamentally different. A decline in the overall stock market can have a significant impact on stock prices, but it typically has a less pronounced effect on the NAV of a mutual fund due to the diversified nature of mutual funds. Investing in mutual funds is distinct from investing in stocks, and therefore, it requires a different exit strategy.
Mutual funds come in various types, and their level of diversification may vary. For example, sector funds tend to have less diversification compared to hybrid or balanced funds. Since mutual funds are diversified in nature, using market timing for exiting from mutual funds may not be an effective strategy, as the fund’s portfolio may include different asset classes and therefore represent different kinds of markets. Additionally, mutual funds aim to generate returns over the long-term and therefore a failure to generate the expected rate of return in the first year of investment may not necessarily be a reason to sell.
Let's examine the factors that should be taken into account when determining whether to sell your mutual fund.
Change in objective of the fund
When investing in a mutual fund, one of the key factors to consider is the fund's objective. For example, if you're seeking higher returns with higher risk, you may choose to invest in a small-cap fund, or if you're looking for a diversified portfolio, you may select a balanced advantage fund. However, over time if the fund deviates from its stated objective, it may be a good idea to liquidate your investment in that fund as it may no longer align with your investment goals and risk tolerance.
In case of an equity fund you can compare the fund's portfolio to its stated investment strategy and objective. If the portfolio contains a significant number of securities that do not align with the fund's stated objective, it may be deviating from its objective. Additionally, the fund's performance can also be compared to its benchmark or peer group to see if it is performing differently than expected. If the fund's returns are significantly different from its benchmark or peer group, it may be deviating from its objective. Finally, you can also read the fund's prospectus and management reports to see if the fund is disclosing any changes to its investment strategy or objective.
In case of debt funds, if the fund’s portfolio contains a significant number of securities that do not align with the fund's stated objective, it may be deviating from its objective. If the fund is investing in securities with a lower credit quality, shorter maturity, or lower yield than what was stated in its investment strategy, it may be deviating from its objective. Another way to identify deviation from objectives, if the fund is deviating from its stated duration or credit quality limits. Debt funds have a target duration or credit quality in which they invest, deviations from that can also be an indication of deviation from objectives.
Therefore, if the objectives of the fund no longer align with your personal investment objectives, it may be appropriate to divest from that fund and consider investing in one whose objectives are better aligned with yours.
Consistent Underperformance
When evaluating a mutual fund's performance, it is important to compare the fund's returns to a benchmark or peer group that is appropriate for the fund's investment objective. For example, if you are evaluating the performance of a small-cap fund, it is important to compare the fund's returns to small cap index or other small-cap funds. If the fund consistently under-performs its benchmark or peer group, it may be an indication that the fund is not meeting its objective and that it may be time to consider selling your investment. It's also important to keep in mind that mutual fund performance can vary depending on market conditions, so a short-term under-performance may not necessarily indicate a long-term trend. It's therefore necessary to observe the performance of the fund over a period of time, such as four to five quarters, rather than making a decision to exit the fund based on under-performance in a single or a couple of quarters. If the fund has under-performed its benchmark or peer group for four to five quarters, it might be the right time to exit the fund.
Change in a Fund’s Manager
It's important to pay attention to any changes in the fund manager, especially if the fund is actively managed, as this can have an impact on the fund's performance. However a change in fund manager should not automatically be a cause for exiting the fund, but it is important to pay attention and investigate the situation. Before making any decisions, it's important to consider a few factors. Firstly, it's important to evaluate if the fund house has the resources and experience to replace the outgoing manager. Secondly, it's important to research the new manager and find out if he has run a similar fund in the past and if he has a good track record. Further, if the investment style of the new manager differs significantly from the previous one, this could impact the fund's performance and strategy. For example, if you have invested in a large-cap fund, but the incoming manager is more focused on mid- and small-cap stocks, you may want to pay attention. The new manager may adjust the fund's strategy to align with their area of expertise, which could lead to a different risk-return profile than you were originally expecting. By considering these factors, you can make an informed decision on whether to keep your investment in the fund or to move it to a different fund.
If the fund is passively managed and mimics a certain index or benchmark, changes in the fund manager may not be as significant, as the fund's returns are more closely tied to the performance of the underlying benchmark or index.
Change in fund’s strategy
When you invest in a mutual fund, it is likely that you have chosen one that aligns with your financial goals, based on your research and due diligence. If the fund manager starts to invest in different financial instruments or deviates from the original investment strategy, it may no longer align with your goals. This can be identified by comparing the fund's portfolio to its stated investment strategy and objective. For example, if you have invested in a large-cap fund but the fund starts investing in some small-cap stocks, the risk and direction of the fund may change. It's important to keep in mind that funds are typically required to notify its investors of any changes to the original prospectus, but it's also important to pay attention to the fund's investments and strategy. Sometimes, mutual funds may change their names in order to appeal to a wider range of customers. In such cases, it is important to be aware that the fund's strategies and investments may also change, so it's important to research and evaluate the fund's new strategy and investments to ensure that it still aligns with your financial goals.
The fund becomes too large
When evaluating mutual funds, investors typically examine the past performance of the fund, and if the fund has consistently generated high returns over its history, it may be considered a viable investment option. As more investors invest in the fund based on its historical performance, the fund's asset size increases, which can lead to a problem of plenty for the fund manager. With a large amount of money flowing into the fund, the manager may find it challenging to find attractive investment opportunities and may be forced to adjust their investment strategy to accommodate the larger asset size. The problem of fund size is more significant for funds that are focused or invest in small- or mid-cap stocks, as these funds typically deal with a smaller number of shares or invest in stocks that have low trading volume and liquidity. This can make it more challenging for the fund manager to invest the large amounts of money flowing into the fund in accordance with the fund’s objective or strategy. To address the problem of fund size, some fund houses stop taking new investments, which can be a positive move for existing investors. However, other fund houses may not take this measure, as their earnings are based on the fund's assets under management (AUM).
The effect of fund size on performance is generally less pronounced for large-cap funds because the market capitalization of large-cap stocks is significantly larger than the size of the fund.
Changes in your investment goals
Changes in your personal goals can also be a factor in deciding whether to exit an investment in a mutual fund. For example, if you initially invested in an equity fund to finance the purchase of a car, but you have now accumulated enough savings to buy the car, it may be time to consider exiting the mutual fund.
Rebalancing your portfolio can also be a factor that may require you to exit an investment in a mutual fund. For example, as you near retirement and your investment goals change, you may wish to move some of your equity investments into a debt fund for capital preservation.
New opportunities
It may be beneficial to exit from a mutual fund and invest in another if better opportunities are identified, particularly in the case of thematic equity funds. For instance, if you have invested in a mutual fund focused on pharmaceutical companies but believe there are better prospects in the metal industry, it may make sense to exit the pharma-focused fund and invest in one that invests in metal companies.
Points to remember
When you decide to exit a fund due to underperformance, it's important to ensure that your asset allocation remains balanced. Instead of moving the withdrawn money from an underperforming equity fund into a different asset class such as debt or gold, you should consider investing it in another equity fund. This way, your overall asset allocation will remain unchanged, and you will still be exposed to the potential returns of the equity market.
When faced with any issues with your mutual fund investments, it's important to take a measured approach and not rush into any decisions. Unlike the prices of individual stocks, the net asset value (NAV) of a fund typically moves slowly, which gives you time to investigate and make an informed decision.
When planning to exit a mutual fund, it is important to consider the tax implications. The amount of capital gains tax you pay is determined by your holding period, with a lower rate for investments held for a longer period. If waiting a few months would put your investment into the long-term category, it may be beneficial to delay your exit to save on taxes.
Conclusion
Mutual funds are typically viewed as long-term investments, and it is generally advisable to hold onto them for as long as possible. However, it is important to periodically review the performance of your mutual funds to ensure they are meeting your investment objectives. If a fund is underperforming or not meeting your goals, it may be beneficial to exit the fund and reinvest the money in other options. Before making the decision to sell a mutual fund, it is important to carefully evaluate the reasons for doing so. If, after thoughtful consideration, you determine that it is the best decision to sell, it is important to follow through with confidence and not second-guess yourself.
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