If your mutual fund is yielding a lower return than you anticipated, you might be tempted to cash in your fund units and invest your money elsewhere. The rate of return of other funds may look enticing, but be careful because there are both pros and cons to the redemption of your mutual fund shares. Let us examine the circumstances in which liquidation of your fund units would be most optimal and when it may have negative consequences.
Mutual Funds Are Not Stocks
The first thing you should to understand is that mutual funds are not synonymous with stocks. Therefore, a decline in the stock market does not necessarily mean that it is time to sell the fund. Stocks are single entities with rates of return linked with what the market will bear. Stocks are driven by the "buy low, sell high" rationale, which clarifies why, in a falling stock market, many investors panic and quickly dump all of their stock-oriented assets.
Mutual funds are not singular entities; they are portfolios of financial instruments, like stocks and bonds, chosen by a portfolio or fund manager in accordance with the fund's strategy. Plus point of this portfolio of assets is diversification. There are many kinds of mutual funds, and their degrees of diversification vary. Sector funds, for example, will have the least diversification, while balanced funds will have the most. Within all mutual funds, though, the decline of one or a few of the stocks can be offset by other assets within the portfolio that are either holding steady or increasing in value.
Because mutual funds are diverse portfolios rather than single entities, relying only on market timing to sell your fund may be a useless strategy since a fund's portfolio may represent different types of markets. Also, because mutual funds are geared toward long-term returns, a rate of return that is lower than predicted during the first year is not necessarily a sign to sell.
When Selling Your Fund
When you are cashing-in your mutual fund units, there are a couple of factors to consider that may affect your return :
If you are an investor who holds a fund that charges a back-end load, the total you receive when redeeming your units will be affected. Front-end loads, on the other hand, are sales fees charged when you first invest your money into the fund. So, if you had a front-end sales charge of 2%, your initial investment would have been reduced by 2%. If your fund has a back-end load, charges will be deducted from your total redemption value. For several funds, back-end loads tend to be higher when you liquidate your units earlier rather than later, so you need to determine if liquidating your units now is optimal.
If your mutual fund has realized significant capital gains in the past, you may be subject to capital gains taxes if the fund is held within a taxable account. When you redeem units of a fund that has a value greater than the total cost, you will have a taxable gain. The IRS has more detailed information on capital gains and their calculations in "Publication 564: Mutual Fund Distributions".
When Your Fund Changes
Do keep in mind that even if your fund is geared to yielding long-term rates of returns, that does not mean you have to hold onto the fund through thick and thin. The purpose of a mutual fund is to increase your investment over time, not to demonstrate your loyalty to a particular sector or group of assets or a specific fund manager. To paraphrase Kenny Rogers, the key to successful mutual fund investing is "knowing when to hold 'em and knowing when to fold 'em".
The following four situations are not necessarily indications that you should fold, but they are situations that should raise a red flag :
Change in a Fund's Manager
When you put your money into a fund, you are putting a certain amount of trust into the fund manager's expertise and knowledge, which you hope will lead to an outstanding return on an investment that suits your investment goals. If your quarterly or annual report indicates that your fund has a new manager, pay attention. If the fund mimics a certain index or benchmark, it may be less of a worry as these funds tend to be less actively managed. For other funds, the prospectus should indicate the reason for the change in manager. If the prospectus states that the fund's goal will remain the same, it may be a good idea to watch the fund's returns over the next year. For further peace of mind, you could also research the new manager's previous experience and performance.
Change in Strategy
If you researched your fund before investing in it, you most likely invested in a fund that accurately reflects your financial goals. If your fund manager suddenly starts to invest in financial instruments that do not reflect the mutual fund's original goals, you may want to re-evaluate the fund you are holding. For example, if your small-cap fund starts investing in a few medium or large-cap stocks, the risk and direction of the fund may change. Note that funds are usually required to notify shareholders of any changes to the original prospectus.
Additionally, some funds may change their names to attract more customers, and when a mutual fund changes its name, sometimes its strategies also change. (For more on mutual fund name changes, refer to Watch Out For The Mutual Fund Metamorphosis.) Remember, you should be comfortable with the direction of the fund, so if changes bother you, get rid of it.
This can be tricky since the definition of "underperformance" differs from investor to investor. If the mutual fund returns have been poor over a period of less than a year, liquidating your holdings in the portfolio may not be the best idea since the mutual fund may simply be experiencing some short-term fluctuations. Though, if you have noticed significantly poor performance over the last two or more years, it may be time to cut your losses and move on. To help your decision, compare the fund's performance to a suitable benchmark or to similar funds. Exceptionally poor comparative performance should be a signal to sell the fund.
The Fund Becomes Too Big
In many cases a fund's quick growth can hinder performance. The bigger the fund, the harder it is for a portfolio to move assets effectively. Note that fund size usually becomes more of an issue for focused funds or small-cap funds, which either deal with a smaller number of shares or invest in stock that has low volume and liquidity. (For more on how mutual fund size affects performance, refer to Does Size Really Matter?)
When your Personal Investment Portfolio Changes
Besides changes in the mutual fund itself, other changes in your personal portfolio may require you to redeem your mutual fund units and transfer your money into a more suitable portfolio. Here are two reasons which might prompt you to liquidate your mutual fund units :
The need to rebalance your portfolio
If you have a set asset allocation model to which you would like to adhere, you may need to rebalance your holdings at the end of the year in order to return your portfolio back to its original state. In these cases, you may need to sell or even purchase more of a fund within your portfolio to bring your portfolio back to its original equilibrium. (Read more about this strategy in Maintaining Your Mutual Fund Equilibrium.) You may also have to think about rebalancing if your investment goals change. For instance, if you decide to change your growth strategy to one that provides steady income, your current holdings in growth funds may no longer be appropriate.
Need a tax break
If your fund has suffered significant capital losses and you need a tax break to offset realized capital gains of your other investments, you may want to redeem your mutual fund units in order to apply the capital loss to your capital gains.
Selling a mutual fund isn't something you do impulsively, without a great deal of thought and consideration. Remember that you originally invested in your mutual fund because you were confident in it, so make sure you are clear on your reasons for letting it go. Though, if you have carefully considered all the pros and cons of your fund's performance and you still think you should sell it, do it and don't look back.