5 reasons to sell a mutual fund

We’re closing out a rocky month for the stock market, which opened 2016 with its worst-ever start to a year.

Because of that you might see some scary numbers when you check your portfolio. But it doesn’t mean you should react. Experts’ advice to long-term investors remains the same: Turn off the news and stick with your plan.

However, don’t interpret that as a recommendation to never change your holdings. Here are five signs that it might be time to sell a mutual fund.

1. It’s exhibiting outsize performance.

This might sound counterintuitive — after all, performance equals return. But outsize performance is another matter: If a fund did significantly better than its peers, you want to find out why, says Paul Jacobs, chief investment officer of Palisades Hudson Financial Group.

“For example, a fund could be borrowing money to boost returns or making investments you weren’t aware of,” he explains.

Dramatic short-term gains could quickly turn into a crash-and-burn scenario. Compare your funds to the appropriate benchmarks, such as the Standard & Poor's 500 or the Russell 3000 index for example, and take note of any outperformance of 5% or more.

Then research the fund’s holdings on its website, Jacobs says. “This should include information such as top 10 holdings and allocations to different industries or countries, which may be enough to get comfortable. If you want to see the entire breakdown of holdings for a fund, you may have to review the fund's official disclosure documents, which should also be on its website.”  Look for investments or manager activity that isn't in the fund's stated investment strategy, or that you aren't comfortable with, like illiquid holdings or currency speculation.

2. It’s showing signs of “style drift.”

Actively managed funds typically carry higher expense ratios than those that are passively managed; investors are paying for a professional to pull the levers. But as a manager’s style gradually changes, a fund can experience “style drift,” Jacobs says. Among other issues, this can cause a fund to essentially track an index, such as the S&P 500 — while still charging a premium.

“Over the long term, these ‘closet’ index funds tend to underperform their benchmark because of the management fees,” Jacobs says. “By monitoring a fund's holdings periodically, you should be able to tell if the fund's strategy is remaining consistent, or if there are shifts happening that you disagree with.”

3. It’s time for you to rebalance.

Rebalancing returns your portfolio to its target asset allocation. Some investors rebalance on a regular cadence. Others do it when their allocation shifts by a certain amount — for instance, when stocks do well and their returns take up a greater share of your portfolio. A portfolio made up of 60% stocks and 40% bonds could quickly become a 70%-30% split instead.

When you rebalance, you sell winning investments — in this case, mutual funds — and use that money to buy additional shares of funds that haven’t performed as well.

4. There’s a less expensive — yet comparable — option.

It’s worth regularly checking whether there are funds similar to the ones you already own, but with lower fees. Within a brokerage account or IRA, you have access to a large selection of funds. (401(k) offerings are typically more limited.) Index funds and ETFs are increasingly competing on fees, which drives costs down.

“If two investors have half a million dollars in something that is virtually identical in terms of investment philosophy and positions, but one is an index fund and tracks the market and the other is an actively managed fund that has similar performance, the difference [in what you’d pay in fees] could be 75 basis points,” says Forrest Baumhover, a financial planner and founder of Westchase Financial Planning. That amounts to almost $4,000 a year.

Market volatility offers opportunity to evaluate your strategy

5.Your risk tolerance has changed.

It bears repeating: A stock market fluctuation isn’t a reason to change your portfolio. But if you’re feeling less able to ride out those fluctuations — whether your current investments keep you up at night, or your goals have changed — it might be time to switch to funds more in line with your current risk tolerance and goals.

“Determine how much risk you need to take to meet your goals,” Baumhover says. “There’s no reason to be going out there on a more aggressive scale if you don’t have to.”

What’s a reasonable mutual fund expense ratio?

To evaluate the fees charged by your funds, compare them to the average expense ratio for the fund category:

● Equity mutual funds: 0.70%

● Bond mutual funds: 0.57%

● Target date funds: 0.57%

● Index funds: 0.11%

Source: Based on 2014 data from the Investment Company Institute

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Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter:@arioshea.

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