When We Exit a Mutual Fund

Thomas BalisMay 12, 2016


Recently, some of our clients may have noticed changes to their fund holdings and thought, “I wonder why they swapped mutual funds in my account?  They sold $10,000 of ABCDE and bought $10,000 of VWXYZ. What happened to buy-and-hold?”

Let’s be clear, there are many, many reasons we make trades to sell a mutual fund. Periodically we rebalance client holdings as the markets fluctuate to ensure we maintain each client’s appropriate asset allocation.  A change in client risk tolerance can lead to some buying and selling. Tax loss harvesting can also result in selling one fund and buying another.

But let’s talk about larger concerns, the kind of concerns that lead us to perhaps a firm wide exit of a given mutual fund.

While staying the course is frequently the right answer when it comes to investing, there are times when circumstances dictate completely selling out of a fund across our entire client portfolio.  Indeed, management changes, style drift, and consistent underperformance to a benchmark are just a few of the outcomes that might prompt us to look at a fund more closely.

Portfolio manager changes are a big deal. Really.  When we consider getting into a fund, we look for a minimum of five years on the fund management team for the least tenured member.  Sometimes, change can be great, such as new talent joining a team of tenured experts.  Other times, however, new leadership can lead to philosophy changes, which can lead to selling out of certain holdings, which can lead to turnover, losses, and worse. So, we watch manager changes closely.

Style drift happens when a mutual fund starts to drift out of its lane.  For example, a Large Cap Value manager may see growth stocks like Amazon and Facebook taking off and decide to buy them to generate some incremental alpha. We may already own those holdings in other mutual funds categories (such as Large Cap Growth!)   This kind of style drift can lead to concentrated holdings and excess risk for our clients, so we monitor our funds quarterly for this kind of activity.

Consistent underperformance relative to benchmark is obviously something we can’t tolerate, but we’re careful to avoid kneejerk reactions.  There are times when a given fund may underperform a benchmark index in the short term due to its investment policies.

For example, if a fund’s investment policies prohibit investments in firms that use debt to pay dividends, then it may not match up favorably with the S&P 500 Index because it won’t be able to buy Apple, which carries a huge weighting in the index. So if Apple has a huge rally, it can move the S&P significantly, yet our fund would miss out for that time period.  However, the other reasons we’re in the fund for the long term may still hold true (e.g. diversification, dividend yield, etc.) So, we generally won’t exit a fund over a bad quarter or two if all of our selection criteria remain solid.

In addition, one thing we won’t do is exit a decent mutual fund to put money in the latest and greatest.  Sometimes, clients mention funds from news shows or magazines that are current category leaders, or just went to 5 stars. At Hoover Financial Advisors, we won’t chase returns.  The data simply doesn’t support doing so.  Research from Vanguard actually shows: “Once the 4- and 5-star funds received their top ratings, their actual performance deteriorated in the subsequent 36 months.” [1]  By the time everyone realizes a particular fund is great, the best returns have already been realized.  Jumping in would be like waiting for the milk to go off sale at the grocery, and then buying it.

Nevertheless, there are indeed times when a fund does have sustained underperformance, and we have to take a harder look.  Whether its poor strategic execution, market conditions, changes in sentiment, or just plain bad luck, some funds simply don’t make it. In fact, since 2000, 81% of US Mutual funds underperformed their index, and 58% of them actually closed. [2]  Therefore, we monitor funds that miss their benchmarks more often than not (called a low batting average) very closely.  If a fund’s struggles continue, other metrics we monitor are also impacted.  Our investment committee meets with the portfolio manager and we then make a decision to stay the course or exit.

Happily, a benefit of changing our investment management services to a discretionary platform is our ability to act timely, instead of needing to wait for the next scheduled annual review for trade approval.   This leads to less risk, better returns, and happier clients.

Clearly, then, there are several, legitimate reasons we might choose to exit a given mutual fund, swapping it with a new one.  Fortunately, it’s not something you see all that often.  In general, the robust nature of our initial selection process for the mutual funds we use means that changes across the entire portfolio are infrequent.  If you are ever curious about a particular change, or maybe even why we haven’t made a change, both the advisor team and the investment management team at HFA are more than happy to answer any questions.


[1] Vanguard Commentary March 2016 ‘Reframing investor choices; Right mindset, wrong market’

[2] ‘Components of Net Equity Returns’, Dimensional Fund Advisors