When is the best time to get out of a mutual fund?
After a recent stock market dip, Ian Bloom, a financial planner in North Carolina got a panicked call from a VIP client: his mom.
“I have to sell everything!” she told him.
He assured her, as he does all his clients, that if she did she would lose much more than she would gain, because they had created a financial plan that already accounted for market sell-offs.
Now would come the hard part: sticking to it.
Fluctuations in the market can leave investors looking at their mutual funds with disdain. They may feel their money could work harder elsewhere.
That may be true. There are situations in which selling mutual fund shares works to your advantage. But you could also encounter adverse consequences.
Move on your strategy not on the market
The time to sell a mutual fund is when you need the liquidity and you have planned ahead to make the move, says Eric Gabor, certified financial planner and founder of Eagle Grove Advisors.
“Any kind of decline in the market or reaction to a geo-political event is not the time to sell,” he said.
Individual investors should only sell funds when their situation calls for a need to make a change, says Amy Hubble, a certified financial planner and principal investment adviser at Radix Financial. Investors may need cash, she says, or need to reduce risk as a need for cash draws nearer.
“Or maybe your target allocation to that asset class has grown outside its tolerance compared to the rest of the portfolio,” says Hubble. “For example, you had a strategic allocation of 10% and it’s now 17% of your portfolio.”
But it can be hard for investors to remember that they need to sit on their hands when they hear bad news.
It’s not uncommon for a novice investor to want to sell their investments when they see declines in the market, says Leah Hadley, a certified divorce financial analyst and chief executive of Great Lakes Investment Management. “That’s why we work with clients to determine an appropriate level of liquidity so that there is less temptation to sell when the market is down.”
Keep in mind that your mutual funds might include more than just US stocks, says Bloom, head of Open World Financial Life Planning.
“Your portfolio will include funds that include different parts of the market,” he says. “Sure there’s the S&P, but there might also be bonds, international and emerging markets. When the market goes down, no one is talking about the other parts, the international investments, the bonds. The part that stands out is the part that is in the red: the S&P.”
Red flags
While your plan is to stick with your strategy for the duration of your timeline, there are mutual fund red flags that could merit a change.
“I will consider making a change in portfolios if there has been a change in the fund’s strategy and it no longer makes sense in my overall strategy with the client,” says Hadley. “I will also sell out of a mutual fund that is consistently under-performing the relevant benchmark.”
Gabor recommends watching the fund manager, too. “If a manger leaves a fund they have managed for many years and a new successor is named, that may be a time to re-evaluate how it fits into your portfolio.”
He adds that investors should also be on the lookout for tax inefficient funds.
“You could get out if there are large inverse tax consequences,” says Gabor. “That’s why I like tax-managed mutual funds, and exchange traded funds.”
Watch out for high turnover ratios, says Hubble, like those over 25% per year. “Funds with high turnover ratios mean the fund is managed tax inefficiently and you’re likely to receive unannounced short-term capital gain distributions at the end of the year, which have high tax costs.”
Another red flag is high expense ratios. “This is the most important number to look at in a fund,” says Hubble. “Do not pay managers more than 1% to underperform the market half the time in long-term savings accounts. Do yourself a favor and for long-term money, skip the active managers altogether and invest in low-cost index funds.”
The consequences of getting out
If an investor does decide to liquidate the fund, keep an eye on your tax liability.
“If the investor has held the fund for a less than a year, all capital gains will be taxed at their income level,” says Timothy Kenney, a certified financial planner and founder of TK Pacific Wealth. “If they have held the fund for greater than a year, they can get a little break in the capital gains tax, maybe 5% or 20% depending on your tax bracket, but they may have a big tax bill to pay next year since we’ve been in a bull market for so long.”
If you have a fund you are looking to sell and it happens to be at a loss, Kenney suggests paying attention to the capital gains distribution.
Funds tend to pay capital gains toward the end of the year, and by selling before the distribution you avoid getting hit with the tax.
Have an investing question? Ask us here to be included in a future column.