Seven Reasons to Sell a Fund

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 fromMorningstar Guide to Mutual Funds: 5-Star Strategies for Successcan 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. Just check out some of the long and lively debates raging on Morningstar.com's Conversation boards. 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
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 in those laggards.

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 may have a problem. You may now have multiple large-value funds in your portfolio and no small-value fund. You may need to sell one of your large-value funds and pick another one in order 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 may shift into a different box, but the strategy hasn't changed. If you are concerned about strictly maintaining your asset allocation, you may want to avoid such funds.

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, for example, that back in 1999, you might have picked up a fund like Invesco Blue Chip Growth expecting a steady, diversified investment style. The fund wasn't as tame as the name implied, however. (In fact, its name changed to  Invesco Growth  in 2001.) It took big risks that sometimes paid off and sometimes didn't. It lost 24% in 2000 and 49% in 2001 due to a stake in tech stocks that reached as much as 71% of the portfolio. Shareholders who thought they were buying a boring blue-chip fund had every reason to sell. They 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 may 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.

The Fund Isn't Living Up to Your Expectations: Although one year of underperformance may 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, such as its Morningstar category or a suitable index.

Taxes are particularly important in making your decision. If you have owned your fund for a long time, you may have built up significant gains, resulting in a tax hit when you sell. Your new pick would have to make many percentage points per year more to make up for the tax damage. (Morningstar.com has a tool called  Trade Analyzer to help you figure out the tax aspects of a swap.) That means that if your star fund has faded to average, selling may 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. (Yes, we're suggesting you break the rule against fund overlap--there's no sense in shifting everything to the superior fund when you will face a hefty tax bill as a result.) On the other hand, if your fund is down enough, you can give yourself a tax break by selling. It could be a win-win deal.

Surprisingly, you may also need to sell if your fund is gaining more than it should. If your intermediate-term bond fund is returning more than 10% per year, it's probably taking on more risk to achieve that return than you would expect to come from the "boring" part of your portfolio. You should at least check the fund's Morningstar Quicktake and Analyst Report to see where those outsized returns are coming from and to determine if that could spell trouble.

Your Investment Goals Have Changed: You don't invest to win some imaginary race, but to meet your financial goals. As your objectives change, your investments should change as well. Suppose you start investing in a balanced fund with the goal of buying a house within the next five years. If you get married and your spouse already owns a house, you may decide to use that money for retirement instead. In that case, you might sell the balanced fund and buy a portfolio of stock funds. Your goal and the time until you draw on your investment have changed. The investment should, too. For the same reason, bonds should become increasingly prominent in your portfolio as you near your goal.

You Can Get a Tax Break: If your fund account is in the red, it might make sense for you to sell and take a loss that you can use to offset future taxable gains. The IRS allows you to use $3,000 of capital losses to offset ordinary income--which is taxed at much higher rates than capital gains. And capital losses that exceed the $3,000 threshold may be carried forward indefinitely. (Be sure to take into account any deferred loads or redemption fees when determining whether to recognize a tax loss. And keep in mind that if you work with a broker, you will also be paying a commission to invest the money.) Selling sooner instead of later is a particularly good idea if the fund looks poor for any of the preceding reasons. You can even sell a good fund if you really need the tax break; just keep in mind that you can't buy it back for at least 30 days or the IRS won't let you take the tax write-off.

You Just Can't Take It Anymore: Even meeting your goals isn't worth it if you develop ulcers or wind up sleep-deprived along the way. Maybe your fund is so volatile that not even the vision of your brand-new house calms you down--every time the fund takes a dip, you see yourself losing another room off your dream house. Sell, by all means (so long as you'd never buy the fund or a fund like it again). The moral: Know your funds, know yourself, and never make the same mistake twice. To avoid getting in that situation again, pay particular attention to how your prospective fund invests and do the gut check. Examine the fund's worst annual and quarterly losses and ask yourself if you would be able to stick out those periods, not knowing if things might get worse, without undue stress.

Learn more aboutMorningstar Guide to Mutual Funds: 5-Star Strategies for Success, including ordering information, by clicking here.