When to sell your mutual funds

By Tim Middleton

Knowing when to sell a fund -- and when not to -- is one of investing's thorniest problems. If you have a 30-year time horizon and invest strictly in index funds, the issue doesn't concern you, but everybody else has to pay it some mind.

Now, the question has become a burning issue for many investors. Diane MacPhee, president of DMAC Financial Services in Glen Rock, N.J., says she's been getting such queries from clients with "an agenda to sell."

In the main, she says, they want to dump their poorly performing funds in favor of hotter portfolios. Like most investment professionals, she's against that in most circumstances. Assuming you've allocated assets wisely, and the funds you've picked to play those roles are doing well, it doesn't matter if one of them is up or down; the whole portfolio should be fine.

But almost nobody can keep their mitts off their investments for 30 years at a time. So we all sell from time to time, and the question for us is more tactical: Is it smart to sell this fund at this time? The answer, I think, can be yes in any of three situations:

• The fund isn't doing its job. The manager's gone to sleep, or been flooded with too many assets to handle, and relative performance is slipping.

• The fund doesn't fit into your plans anymore. For example, 100% of your funds are invested in stocks, and you're five years from retirement, so you need to worry as much about preserving capital as growing it. Some of those equity funds will have to go.

• It's the wrong time to own this fund. By far the most controversial reason to sell, market timing is an issue most of us treat as warily as an unexploded shell. Sector rotation and other forms of timing are hard to pull off. Hard -- but not impossible.

Sheldon Jacobs, editor of the No-Load Fund Investor newsletter, was completely out of technology funds by February of 2000, just before the Nasdaq cratered. He was also holding 40% cash, in contrast to being fully invested with a hefty tech concentration one year earlier. Tech stocks were "tremendously overpriced," he says. Timing decisions are one of the raisons d'etre of investment newsletters like his.

Inexplicable decline

The surest sign a fund has overstayed its welcome in your portfolio is a sustained and inexplicable decline in its performance, relative to other funds of its type. Funds fill roles, like a core large-capitalization strategy, or small-cap growth. If the average big-cap fund has delivered annualized returns of 10% over the last five years, and yours has gone from beating the average to trailing it, why would you want to own it?

"Is this the same fund that I bought?" asks Diahann Lassus, a principal of Lassus Wherley & Associates, a financial advisory firm in New Providence, N.J. "Is it acting the same way, living up to its objective? If not, why not?"

She's talking about relative, not absolute, performance. When value investing is out of style, for example, even the best value funds will languish.

"Simply doing poorly is a very poor predictor of future performance," says Eric Kobren, executive editor of the Fidelity Insight newsletter. "You have to know why." Taking the Heartland example, if it had done well in the mid-'90s, it would have meant it had abandoned its mandate.

Unexpected outperformance, in fact, is a much better reason to unload a fund than expected underperformance. Legg Mason Value Fund (LMVTX) was dazzling when most value funds were in the dumps, and for that reason alone was shunned by value investors.

The reason for the outperformance was obvious: Despite its name, it wasn't a value fund. When value began to shine, in 2000, Legg Mason began to bleed red ink, and it continued to do, along with other growth funds. An investor who thought the fund would protect him during a bear market hadn't done his homework.

Reducing risk

Sometimes a perfectly good fund will have to go, however. Suppose you want to buy a car in two years, or retire in five. Your all-equity portfolio is poorly prepared to meet these goals, because stock prices are so volatile. You need to put short-term money into something more reliable, like a short- or intermediate-term bond fund, or a money market account.

You have a variety of options in selecting sale candidates. You could sell equal amounts of all your equity funds -- say 20% -- and put those funds into bonds. Or, you could decide after a thorough analysis that one of them is straying from its goal or falling short of meeting it, and sell it alone.

Or you could decide to sell the fund you have reason to believe will do less-well than the others in the two to five years that are your time horizon. If you were making this choice at the end of 2000, for example, you certainly would not have sold any of your value funds (except Legg Mason) because they were just entering the sweet spot of what is ordinarily a multi-year trend of outperformance.

Jack Bowers, editor of the Fidelity Monitor newsletter, in 2001 advised subscribers to cut back their holdings of large-capitalization growth funds and put the proceeds into small- and mid-cap value funds. "It was clear which areas of the market were attractive and not so attractive," he says.

This is the least extreme version of market timing. The most extreme is moving 100% of assets between stocks, bonds and cash -- and it's very widely practiced. The No-Load Fund X newsletter specializes in this form of sector rotation.

"When the market leadership changes, we follow it," says Janet Brown, the newsletter's editor.

Brown doesn't try to predict changes in the market's direction; she's content to jump on board once they're clear. "These trends are fairly long term; the growth/value cycles tend to go on for five years," she says. "Our system will never get us in on day one, nor will it get us out at the top, but we will capture the majority of the trend."

When you analyze your portfolio the next time, give these approaches some thought. A fund doing too poorly -- or too well -- can easily be replaced, either with one of its own kind, or with one more in tune with the current market.

Just don't sell a fund for doing its job. That's always a mistake.

At the time of publication Timothy Middleton didn't own any securities mentioned in this article. Middleton is the author of "The Bond King: Investment Secrets of PIMCO's Bill Gross" and the former mutual funds columnist of The New York Times. He works from home in Short Hills, N.J.