3 Good Reasons to Sell a Fund

In my earlier column on creating an on-watch process for funds in your portfolio, I outlined the factors that might lead you to place a fund under heightened scrutiny. But that’s only part of the story.

Eventually--and this period could range from a few months to a few years--the time to make a decision draws nigh. You’ve reviewed the data, read articles and reports on Morningstar.com or elsewhere, and now you have to decide: Take the fund off the watchlist or cut ties altogether?

We deal with this quandary often on the manager selection team at Morningstar. Sometimes the decision is clear-cut, but often it remains fuzzy, even after considerable analysis. Ultimately we are guided by our fiduciary duty to clients and the knowledge that we often have equal or better alternative managers available in our universes. As an individual investor, you may face complicating circumstances, especially taxes and replacement options. But you nevertheless have an obligation to do what’s best for your financial future, so don’t be afraid to make the tough calls.

Before Hitting the Sell Button Before going any further, I should acknowledge one of the biggest reasons many investors are selling funds these days--to switch to passive from active strategies in order to gain the benefits of simplicity and lower costs. My focus in this column, however, is more on actively managed funds, and situations where your on-watch process has led to significant concerns. (It's possible for passive funds to end up on watch as well, but the use cases for doing so are less common.) Of course, should you decide it is in fact time to sell a fund based on any of the factors below, replacing it with a passive strategy is always an option.

There are a couple of other caveats that investors should keep in mind before making any final decisions.

First, before cutting a fund loose, it’s a good idea to put any fund you’re considering selling on a watchlist (you can review my description of the process). That acts as something of an emergency brake on what can be a natural instinct to act hastily when a fund underperforms or experiences a manager change.

Second, before making the final decision to sell out of a fund, consider two important factors: the availability of alternative options and the tax consequences. If you are dealing with a retirement account such as a 401(k), tax consequences will be immaterial but replacement options may be an issue. On the other hand, if you are working with a taxable account, tax consequences will be preeminent, while finding an alternative will likely be less of a burden. Both of these issues bear further discussion, somewhat beyond the scope of today’s column. However, at a minimum, you may want to review any potential tax consequences of a fund sale with a financial advisor or tax professional.

Potential Triggers to Sell I'm going to home in on potential sell scenarios from three of the four criteria I identified in my watchlist column: manager change, a portfolio change, and unexpected performance patterns. (Fee changes was the fourth.)

1) Inferior Replacement Manager There are many cases where a manager transition runs smoothly, with a long-groomed successor easily picking up the reins from the previous portfolio manager and implementing the existing philosophy seamlessly. At other times, the transition can be rough. Particularly concerning situations involve those where a manager departs unexpectedly and no experienced replacement sits as an immediate replacement, or where an iconoclastic manager at a boutique firm has failed to adequately develop successors. T. Rowe Price is well-regarded for its generally smooth manager transitions, for example, as was the case when Nina Jones replaced retiring manager David Lee at the start of 2019; Jones had been an analyst under Lee from 2008 to 2015 and had more recently been running T. Rowe Price's global real estate fund. At the same time, the firm was on the wrong end of a manager departure when star manager Henry Ellenbogen of T. Rowe Price New Horizons PRNHX left unexpectedly in March 2019, taking some of his crew with him.

Keep in mind that even a sudden manager departure is rarely a matter for immediate concern, because a mutual fund portfolio is generally a slow-moving ship, and presumably the fund’s holdings are there for good reason and won’t inherently be affected by the manager’s departure. However, after you have observed the fund on watch for a meaningful period, you could have a strong rationale to sell if one of the following conditions applies: a) the new manager installs a process and/or philosophy significantly different from the one that originally persuaded you to purchase the fund; b) the new manager lacks credible experience and/or the transition has been accompanied by other investment personnel departures; or c) the fund experiences a deterioration of performance under the new manager not explainable solely by market conditions and tied to poor managerial decisions. These would all be cases where, assuming you have superior options available, selling the fund would be a strong consideration.

2) Pronounced Shift in Portfolio Mandate or Composition If you placed a fund on watch for a significant change to its investment style (as opposed to simple style drift), during the watch period you should be investigating to ascertain the magnitude, rationale, and duration of those changes. Although it's not common, changes can happen--sometimes precipitated by fund-company mergers or other firm-level structural overhauls--that lead to fundamental shifts in a fund. Such was the case, for example, with Berwyn Income BERIX. When its management team unexpectedly departed, the fund's new strategy was a dramatic departure from the original; parent company Chartwell replaced its previously specialized income strategy with a conventional allocation strategy anchored by a mid-cap value equity sleeve and a core-plus fixed-income sleeve. (Berwyn Income would also have been a watch candidate owing to its manager change, which points to the fact that concerning situations often hit multiple triggers.) Unless the new version of a strategy is so compelling that you would want to invest in it regardless, such a scenario is likely ripe for a sale.

Another likely sale scenario under this heading would be a situation where a manager has tipped portfolio holdings into more-illiquid or risky securities than expected--an equity manager who starts loading up on private investments, for example, or a fixed-income manager who invests heavily in unrated distressed debt. That latter scenario occurred, notoriously, with Third Avenue Focused Credit, which ended up gating investors and ultimately liquidating. A related situation would be excessive concentration--Sequoia Fund’s SEQUX disastrous investment in Valeant comes to mind. These are cases, where, had you placed the fund on your watchlist, you might consider acting more quickly than in other circumstances.

3) Underperformance With Accompanying Risk Factors When we place a fund on watch for performance as part of our fiduciary review process at Morningstar, we undertake a thorough review of the sources of underperformance, with an eye toward long-term trends and changes in performance patterns versus expectations. Performance is always complex to analyze, and Morningstar research has shown that even the best managers often go through long dry spells. So it pays to be patient.

Nevertheless, there are certainly situations where an underperforming manager, in combination with other structural factors, should prompt you to consider unloading a fund. (When I speak of underperformance, I’m referring especially to degradation of alpha and/or risk-adjusted returns.) One is when underperformance is associated with asset bloat--for example, a successful fund may spawn heavy inflows, which then limits the manager’s ability to invest as nimbly in smaller caps that helped generate the original success (such a scenario likely would also trigger your watch criteria for portfolio shifts). Another is when underperformance is accompanied by turnover or restructuring within the fund’s management team or the supporting analyst resources. Both situations suggest that the manager may have difficulty recapturing previous success.

A Final Thought Parting ways with a manager can be tough, particularly if it’s one you’ve held for a long time or had past success with (a quandary I described in personal terms in my previous column). And a long-term, strategic view is always a best practice. But when the conditions are right--you have access to acceptable alternatives, and the tax consequences of a sale are manageable--and a fund you own has fallen into one of the more concerning situations I’ve described above, trust your process and go ahead and make that decision to move on.