10 reasons to dump a mutual fund

By Larry MacDonald

Globe Investor Magazine Online, April 9, 2008

When stock markets turn down, you might develop a yearning for the investment strategy outlined in Dave Barry’s book, Money Secrets. The award-winning humorist summed up the central tenet as follow: It’s an absolutely foolproof system for making money in the stock market, requiring only a little effort and access to time travel.

Many people would indeed welcome the opportunity to hop into a time machine and unload their mutual funds at last year’s peak in the market.

But financial advisers usually counsel clients to buy and hold and calm them with sayings like, It’s time in the market, not timing the market. That’s generally sound advice given the historical tendency of stock markets to return 7 to 9 per cent a year over the long run.

However, there are occasions when selling a mutual fund is justified. Here are 10 to consider, while keeping in mind the impact of deferred sales charges, short-term trading fees and taxes.

1. Valuation.

Many seasoned investors believe in shifting out of stocks when market valuations become too rich or the mood too euphoric. For example, famed investor Stephen Jarislowsky of Jarislowsky Fraser writes in his book The Investment Zoo: If the average price/earnings ratio has historically been 14 to 15 times earnings and it goes up to 24 to 26 — reduce the number of stocks you own in favour of cash or short-term bonds.

2. Underperformance.

A drop in the unit value of a mutual fund is not cause, per se, for dumping. What might really provide cause is underperformance relative to peer benchmarks over a period of three years or more, says Ken Kivenko, investor advocate and publisher of website CanadianFundWatch.com.

3. Volatility preference.

If your fund is more volatile that others, that may be a warning sign. Risk-adjusted returns are a useful supplementary measure, adds Mr. Kivenko. That is, a fund may yield a higher return over the long run but have wide fluctuations that unnerve some investors. Their preference would be for a smoother progression, even though the return may not end up as high.

4. Fix mistakes.

Sometimes mistakes are made and they need to be corrected. A common error is buying too many funds. If you have three or four Canadian equity funds you are over diversified in the Canadian market — you will only earn the index return less the management expense ratio, warns Warren MacKenzie of investment advisory firm Second Opinion Investor Services Inc.

5. Fund changes.

Mutual funds can change. Changes can take many forms, such as a merger with another fund, change in mandate, change in managers or change in fee structure, notes Dan Hallett of investment research and counselling firm Dan Hallett and Associates Inc. Therefore, you might sell if a new investment style or manager doesn’t jibe with your preferences, or if fees are getting out of hand.

6. Rebalancing.

Successful funds can grow to become relatively large holdings within a portfolio, resulting in a risk profile different from preferences. So part of the successful fund may be sold off to rebalance and lower exposure to one manager or asset class.

7. Fund size.

If a mutual fund has grown to become large relative to the market, it might be replaced. Large funds are effectively constrained to market-like portfolios and no better than market averages. Actually, if returns are the same as the market, and annual management expense ratios (MERs) are then deducted, the return on a net basis will tend to trail the market by the MER amount.

8. Better opportunity.

One of the rules of legendary investor Sir John Templeton is to sell when a better opportunity has been found. So don’t hold on to a loser in hopes it will recover. If you see a better opportunity in the mutual fund universe, shift into it.

9. Change in investing approach.

As investors gain experience and/or greater wealth, they may want to consider other vehicles. For example, Mr. Kivenko recommends switching out of high-fee mutual funds into index funds and exchange-traded funds because they charge less than half the fees. Considering mutual-fund managers tend on average to track the market, low fees are the most important factor influencing long-term performance, he claims.

10. Personal needs.

Investors will likely want to sell down equity mutual funds once a savings goal is reached such as the onset of retirement. To reduce the risk the stock market is in a downswing when it comes time to withdraw money, the investor should phase in a shift to less risky, income investments.

Special to The Globe and Mail