Need reasons to sell a fund? Here are 7

December 07, 2003|By MORNINGSTAR.COM

Buying funds is easy. You find an offering where everything looks good and you've got no worries. But a few years later, things might not look so good. Maybe the manager has left, performance has fallen off, or assets have swelled. Now, you've got to figure out whether to stick it out or bail, and that's no piece of cake.

The following excerpt from Morningstar Guide to Mutual Funds: 5-Star Strategies for Success can help you make a good decision.

The first step in deciding whether to sell is identifying why you own the fund. What was your rationale for buying it? Did you admire the portfolio manager's track record? Then you'll need to keep an eye open for manager changes. Did you love the industries the fund invested in? Then you need to look for changes to the portfolio's sector weightings. Did you buy the fund to fill the large-cap value slot in your portfolio? Then you should pay particular attention to its style.

The tricky part is figuring out when to sell. Most of us can agree on what to look for when buying a fund - good risk-adjusted returns, long manager tenure, etc. - but we part ways on when to sell. None of us wants to be one of those investors who undermines his or her returns by buying and selling at the wrong times. Yet some situations almost demand that we hit the sell button.

Seven good reasons to sell:

1. You need to rebalance: Even if your investment goals have remained the same and you have not tinkered with your asset allocation, you'll probably need to get your portfolio mix back to its original state. If your stock funds didn't fare well in a given year, rebalancing probably will require putting more money into those laggards.

2. The fundamentals have changed: Presumably, you buy a small-value fund because you want exposure to small-value stocks. If the manager starts buying large-value stocks, you might have a problem. You might now have multiple large-value funds in your portfolio and no small-value fund. You might need to sell one of your large-value funds and pick another one to restore your original balance of styles.

Be careful how you define a change in style. Sometimes a manager's stocks will change, but his strategy won't. Baron Asset (BARAX) is a case in point. The fund didn't migrate from the small-growth to the mid-cap growth category because manager Ron Baron began buying larger stocks. He still buys small-cap issues; he just holds on to them as they move into mid-cap or large-cap range.

Similarly, Longleaf Partners (LLPFX) occasionally wanders from mid-value into mid-blend. Like Baron Asset, Longleaf Partners keeps turnover low. As its holdings prosper, they might shift into a different category, but the strategy hasn't changed. If you are concerned about strictly maintaining your asset allocation, you might want to avoid such funds.

3. You misunderstood the fundamentals: Closely related to changing fundamentals are misunderstood fundamentals. If you buy a compact disc that's cracked or a shirt that doesn't fit, you return it. Sometimes, investments need to be returned, too.

Let's say that in 1999 you picked up a fund such as Invesco Blue Chip Growth expecting a steady, diversified investment style. The fund wasn't as tame as the name implied, however. (Its name changed to Invesco Growth [FLRFX] in 2001.) It took big risks that sometimes paid off and sometimes didn't. It lost 24 percent in 2000 and 49 percent in 2001 because technology stocks reached as much as 71 percent of the portfolio.

Shareholders who thought they were buying a boring blue-chip fund had every reason to sell. They had made a mistake. Rather than hang on to a mistake in the hope that it works out, it makes sense to switch the money to a more compelling investment that you feel more comfortable with.

You might also realize that you overlooked one of the most basic issues, the effect of high costs. If your fund is overpriced, you could save a lot of money and improve your returns by picking a cheaper option. But don't overlook the possible tax impact of switching funds.

4. The fund isn't living up to your expectations: Although one year of poor performance might be nothing to worry about, two or three years of falling behind can get frustrating, to say the least. Before cutting the fund loose, though, be sure that you're comparing your underperformer to an appropriate benchmark.

Taxes are particularly important in your decision. If you have owned your fund for a long time, you might have built up significant gains, resulting in a tax bite when you sell. Your new pick would have to return many percentage points more per year to make up for the tax damage. That means that if your star fund has faded to average, selling might not be a good idea.

If you think you can do better but want to avoid the taxes, put new money to work in a new fund. If, however, your fund is down enough, you can give yourself a tax break by selling. It could be a win-win deal.

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