Five Popular Reasons for Selling Mutual Funds, and Why You Can Ignore Them

Which do you think is the more difficult decision—knowing when to buy a mutual fund or knowing when to sell it?

In theory, they're equally difficult, because you're just as unlikely to buy at a bear market bottom as you are to sell at a bull market top. But as a practical matter, you're likely to have more difficulty with the selling side of the equation. That's because when buying, you typically have a stimulus to help you along—an adviser/broker, financial magazine, or (blush) a successful investing newsletter with an outstanding track record. Couple that stimulus with the natural optimism of most investors (we doubt if you buy a fund expecting it to be a disaster), and it's not too hard to take the leap, especially at lower dollar amounts.

But on the sell side, the same forces that got you into the fund now conspire to keep you in. Most advisers/brokers are not predisposed to issue sell advice. They typically expect you to hold the fund for many, many, many years. Financial magazines almost never write follow-up articles suggesting that a previously recommended fund be sold. And that optimism that helped you decide to buy now tells you not to sell. If the fund is down, you prefer to believe it will go back up (and besides, you "wouldn't want to sell at a loss" now, would you?). Or if the fund is up, you optimistically believe it will continue its winning ways.

Fortunately, you have us to sound the alarm and tell you in no uncertain terms that it's time to sell the fund and move on (as we did this month in grand fashion—see New Fund Recommendations for September ). And in doing so, we didn't rely on any of the five most commonly cited reasons for selling a fund—the conventional wisdom of Wall Street, if you will—in arriving at our recommendations. Those rationales are irrelevant to Upgraders, as we'll explain shortly.

But first, let's look briefly at why it is the investing community generally has a bias against advising you to sell your current fund holdings. We'll start with this quote from Marketwatch.com a few years ago: "...the average annual return on a stock fund from 1984 through 2002 was a touch more than 10.2 percent. The average stock fund investor, however, earned less than 3 percent. The difference between what the average fund earned and what the average investor got is found in portfolio moves, in switching from one investment to the next, typically in an effort to find the hot hand. And current market conditions are just the type that make otherwise sane investors go chasing performance."

Studies like the one cited lead Wall Street to believe that you hurt yourself more than help yourself when you switch funds. But the problem is not in the switching. The problem is that, for most investors, there's no rhyme or reason to the switching. Listening to the conventional wisdom, you would never guess that a strategy using our Upgrading guidelines would have any chance of doing well. After all, don't we "chase performance," looking for managers with a "hot hand"? These apparent hallmarks of investing insanity are two no-nos that are constantly berated in the media, but they rarely take the time to define their terms. These shallow assessments are all too common.

The Marketwatch quote refers to the performance of the average stock fund as a benchmark. Let's look at more recent data. Over the past five years, from 2001-2005, the average U.S. stock fund returned 3.9% annually (per the Morningstar database). Our Upgrading strategy returned 11.6% annually. How are these results possible, given our preference for cutting and running from fund managers who have fallen behind their peers in the performance race? They're possible because switching isn't the problem that is blocking better performance; switching (as practiced in our Upgrading strategy) is the path to better performance. The fact is that it pays to set a high performance standard which you expect your fund managers to maintain, and to have a disciplined way of setting selling points when they fail to do so.

THE CONVENTIONAL WISDOM ON WHEN TO SELL

Reading the financial media regularly as we do, we frequently come across articles that give advice to investors on when it may be time to sell a fund. Here are the five most common reasons for selling that, were we not using Upgrading, might have some merit. As it is, we don't rely on them at all.

• Sell if the expenses are too high. This advice is more commonly delivered as don't buy if the expenses are too high, but the point is the same. The thought process here is that future returns are unpredictable, but future expenses are predictable, so focus on what you can predict by avoiding funds with high expenses. This is absolutely true for money market and bond funds, where most of the difference in returns from one fund to another can be explained by differences in expenses. But stock funds are a different story. One study by Burton Berry examined over 400 stock funds and concluded that less than 2% of the variability between their returns was due to the expenses charged.

While there may be some correlation between fund expenses and returns when applied to averages of thousands of funds over extended time periods, the correlation between your specific stock fund's return over the next year or two and its expense ratio is virtually nil. Picking funds based on low expense ratios is unlikely to guide you to superior performers over the next few years.

Upgrading disregards expenses entirely in its fund selection formula, given that each fund's expenses are already reflected in the performance numbers our rankings are based upon. In other words, any recommended fund with an above-average expense ratio has already more than compensated its shareholders with higher returns, because the stated returns that caused it to rise to the top of the Upgrading rankings reflect the gains left for the shareholder after all expenses have already been deducted.

• Sell if the fund becomes too large. This is a good theory that runs aground on defining exactly what "too large" means. We've seen funds with less than $100 million close their doors to new investors, while others perform exceptionally well with assets of over $1 billion. The only person truly able to determine if the size of the fund is becoming problematic is the manager. Unfortunately, because a fund makes more in fees as it grows larger, the manager often has a powerful incentive to keep a fund open beyond its optimal size. This is confirmed by the fact that closed funds as a group have a fairly mediocre track record, indicating many waited too long to close and lost their ability to deliver superior investing performance.

Rather than guess at what asset level might cause a manager to start having problems, Upgrading takes a more pragmatic approach. Since you can't fake actual returns, Upgrading assumes if a fund's performance has been good enough to carry it to the top of its peer group, the fund's size can't be exerting much of a negative impact on returns. Given that, we're happy to own a fund that's "getting too big" until such time as those extra dollars actually begin to impair performance.

How do we know when that is? When a fund slides down the rankings and passes below the quartile of its peer group. (Actually, when that happens it's difficult to say the fund's size was the problem. But when a fund isn't falling down the rankings and continues to post superior performance results, it's easy to say that the size of the fund has not yet become a problem. Once again, we can comfortably wait for Upgrading's sell discipline to alert us to any trouble, at which time we sell the fund and don't worry whether it was the fund's size or another factor that caused its decline.)

• Sell if there's a change in management. Having the manager leave a fund would be a cause for concern if you (1) believe the manager is primarily responsible for the fund's excellent ranking, and (2) plan to stay invested in the fund for an extended period of time. Since these are taken for granted by the conventional wisdom school of fund buying, it's easy to see why a manager leaving is always on the list of reasons to sell a fund (or at least be gravely concerned about the departure).

In Upgrading, we don't accept either of these core assumptions. Regarding manager skill, we definitely agree some managers are more skilled than others, and we prefer to invest in funds run by the best of them! But we also believe that the market shifts its favor between the various asset classes, sectors, investment styles, and management approaches as we move through the various phases of the business cycle.

When a particular style is being favored, most of the funds using that style are going to do well. Sure, the ones with the "best" managers are probably going to rise to the very top, but even those funds run by lesser managers are likely to look pretty good. So if a fund on our recommended list undergoes a manager change, we don't feel any reason to panic. In all likelihood, the fund will continue to perform fine for as long as that particular style is in favor. When the favorable period ends, the fund will likely decline just as it would have with the original manager.

Which brings us to the second point, the underlying assumption that you'll own the fund for a long time. If that were true, sure, you wouldn't want to settle for a lesser manager in that particular style. But as Upgraders, we have no illusions about owning the fund for the long haul. We know up front that if everything goes fantastically well, the longest we're likely to own the fund is a couple years, with 9-12 months being a more realistic average. Over that time span, the market's rotation is likely to be a stronger factor than the manager's skill, so we can definitely afford to be patient and see how the change affects performance.

As always, SMI's momentum rankings are the final arbiter of whether a change at the fund has had a negative impact. If there's no decline for the fund in the rankings, there's no problem for us. If there is, we sell and move on, either to a fund following a different style that the market is now smiling upon, or to another fund of the same style with a manager who is more in tune with the current market environment.

• Sell if the manager trades heavily. The argument against high turnover goes like this: excessive trading generates costs beyond the expense ratio that are very damaging to overall performance. Usually the author states that these costs are "invisible" to you, or somehow communicates that these shadowy costs are to be feared because they are harming you without even being detectable. Like radon gas, you think everything is fine, while all the while these high turnover costs are poisoning your portfolio. Nonsense. While there definitely are costs involved with a high turnover strategy, and while those costs aren't detailed clearly for investors like the expense ratio is, those costs do show up in the only place that really matters—the final performance of the fund.

The reality is that everything that goes on at a fund, good or bad, ultimately gets condensed into one final number, which is the return the fund makes for its investors. There's no hiding anything beyond that final number. Is high turnover expensive? Absolutely. It raises the performance hurdle, because now the manager has to outperform the market's return, not just by the amount of the fund's expense ratio but also by the associated costs of the rapid trading as well. But if a manager can clear that hurdle and generate great performance after all those costs have been accounted for, do you really care that those costs exist? We don't. If the costs get too large, guess what will happen? The fund will fall down in the momentum rankings and will be replaced. But there are times when owning funds that follow rapid trading strategies is very rewarding, and we'll gladly ride along during those times.

One exception should be noted here. For investors in taxable accounts, the cost of high turnover can strike through higher taxable distributions. Taxes are the one way a high turnover fund can hurt that the Upgrading fund rankings won't protect you from. Naturally, this doesn't apply to investors in tax-deferred accounts.

• Sell if the performance lags its peers over the past three (or five, or ten) years. If long-term performance were a good predictor of future returns, the Morningstar star ratings should be an effective guide to selecting funds, as they are based purely on performance over the past three, five, and ten years within fund peer groups. The reality is, by Morningstar's own admission, the star ratings are almost useless as predictors of future excellence. Why? Because long-term track records simply aren't a helpful guide to predicting future performance.

LEGITIMATE REASONS FOR SELLING FUND SHARES

The five "reasons" to sell we've just discussed all stem from the same fundamentally flawed assumption: that you're going to buy and hold the same funds for a really long time. That's a losing premise to start from. Studies repeatedly indicate that somewhere around 75% of actively-managed funds fail to keep up with their respective market index over extended time periods of 10 years or more. For most funds, there just aren't enough periods of superior performance to overcome the additional expenses of active management.

If you insist on using the "buy-and-hold-forever" approach, you are almost guaranteed to underperform a good portfolio of index funds, regardless of which funds you choose. That doesn't mean you should just give up and buy index funds, but it does require that you abandon the conventional wisdom and take a different approach.

We believe the main reason you should sell a fund is because its performance has lagged its peers over the past year, weighing the recent months more heavily. That's the selling discipline built into our Upgrading strategy, and the chief reason for its long-term success. Chances are, if you're reading this here at SMI, you're already convinced Upgrading is the surest path to mutual fund success. But you may be surprised to find we think there are times you should sell a fund even though it continues to perform well and remains on our recommended list. We can think of three "good" reasons to sell such a fund.

• Sell if you're changing your asset allocation and you need fewer stock fund holdings. Your most important investing decision isn't which funds to buy. It's not even whether to use Upgrading or not (gasp!). No, your most strategic investing decision is how much you allocate to stocks vs. bonds in your portfolio. Studies have indicated as much as 90% of your total return may be dictated by your asset allocation. So if your optimal asset allocation dictates reducing your stock holdings, you should sell stock funds to follow that optimal allocation, even if all the funds you own are all-star performers.

Why might you want to reduce your stock allocation? It could be that you're following our suggestions (see Upgrading: Easy as 1-2-3 ) and have moved into a time frame closer to retirement that calls for a slightly more conservative posture. Or perhaps the current season of market weakness has you rethinking your risk temperament and you realize you're not the "daredevil" you originally thought. Or you may have met one of your specific investing goals.

Remember, investing is about attaining goals, not accumulating ever-increasing fortunes with no reasonable purpose. The former is biblical and lauded, the latter is hoarding and condemned. Some goals are very clear-cut, and when you reach them, you should act to reduce risk so as not to lose money and fall below the amount needed. One way to do so is to lower your equity exposure by selling stock funds.

• Sell if your annual rebalancing requires that you reduce your allocation to stock funds. If your stock holdings have gained in value and you need to sell some to get back to your target allocation, you should follow your target allocation even if all your current holdings are winners. Being too heavily invested in stock funds is a good way to shoot a hole in an otherwise solid long-term plan.

• Sell if a change in management philosophy or execution moves the fund into another risk category. A common term for this is style drift. If you buy a fund to fill a certain slot in your portfolio and it starts investing in something else, it can throw your overall portfolio allocation out of balance. For example, if a fund you bought to fill the "foreign" slot in your portfolio began investing primarily in U.S. stocks, you'd not be getting the international diversification you sought. In that case, it doesn't really matter if the fund is doing a good job picking U.S stocks—it isn't doing the job you bought it to do, so you should sell it and find a replacement fund that will.

What do these "good" reasons for selling have in common? They're all "inside-out" reasons. Each stems from your own financial needs and the long-term strategy you've put in place to meet those needs. They're not externally driven, based on what the markets are doing or what the talking heads on TV happen to be saying. When your selling decisions are flowing out of an analysis of your personal needs and individual circumstances rather than the external conditions surrounding a particular fund (or the markets in general), it's a good indication your thinking is on the right track.

• Learn about the SMI Investing Strategies
• SMI's Investing Principles page
• SMI's Recommended Funds page [PDF]  
• Upgrading: Easy as 1-2-3 
• Make Sure Your Investment Decision-Making Is Inside-Out
• "You Got to Know When to Fold 'Em" 

• Got a question or comment about this article? Discuss it on our Message Boards.