When To Sell A Fund

When to Sell a Fund

As part of monitoring your investments, you should have defined reasons when to sell a fund. It is important to distinguish between market timing and valid reasons for selling. Don’t sell an index fund and buy an actively managed fund just because the active fund has outperformed recently. That is performance chasing – and you need to guard against this.

There are a couple of scenarios when you might want to sell a fund, primarily if it is to fix your portfolio. There is probably not a bad time to do this, although investors often agonize over the timing of moves. We cannot predict the future. If you know your portfolio has problems, make those changes and move on.

Three Sales to Fix Your Portfolio

First, if you have narrow funds, such as a sector fund, I would suggest you sell those and get into a broader index fund. If you are up, and have a nice gain, go ahead and sell. Don’t wait until the fund or stock has tanked. If it has tanked, take your loss and learn a lesson. You may hope that it will come back, but hope is not a good investment rationale. While you are waiting for it to come back, perhaps you could be growing your portfolio in an index fund.

I’m not going to recommend that you try to own individual stocks in your portfolio. That is speculative and a distraction for most investors to growing your wealth. I know many millionaires who invest in funds, but not many who got there with individual stocks. The majority of people who are trading stocks have tiny accounts. According to the NY Times, the popular trading app, Robinhood has only an average account of $4,800. Focus on your accumulation and being a market participant, not a speculator. If you’ve had good luck with individual stocks, take your gains and get into index funds. 

Second, if you are invested in a fund or product that has high expenses, switch to a low-cost index fund. For example, if you have an actively managed fund, an A-share mutual fund with 12b-1 fees, or a fund in a Variable Insurance product, your expense ratio might be 0.75%, 1.00% or more a year. An index fund might be one-tenth of that, 0.10% or less for many categories. When your goal is long-term growth through market participation, costs are a direct drag on your performance. That’s a good reason to sell.

Interestingly, the average active manager often (slightly) beats their benchmark before fees. It’s just that the drag of a 1% expense ratio, in a market that returns 5% or 10%, eats up all the benefits the managers can create. Over time, low expenses are correlated with better performance.

Third, you may want to sell some of your funds to establish your target asset allocation. Most of your performance is based on your overall asset allocation. I see many younger investors who start out 100% in stocks and as they grow their wealth, eventually realize that they need some bonds. Other investors have some bonds, but no target allocation to use for rebalancing. So, start with your recipe first and adjust your funds to fulfill your target allocation. Otherwise, you end up with a poorly diversified portfolio.

Staying Invested

If you are already invested in a low cost, diversified index fund, why sell it ever? I can think of two good reasons: rebalancing and tax loss harvesting. Outside of that, investors can do quite well by having little or no turnover and sticking with low cost Index funds for not just years, but decades.

What aren’t reasons for a long-term investor to sell? Coronavirus. Elections. Business cycles. News.

Sure, those things can impact stock prices in the short-term. But staying the course in an Index Fund seems to work better than any other strategy. So, yes to selling sector funds, single stocks, and high-expense funds to replace them with an Index Fund. Yes to the occasional sale for rebalancing or tax loss harvesting. Outside of those reasons, try to keep your diversified allocation and stick with your index funds. Now, if you are within five years of retirement and are concerned about risks to your retirement income, let’s talk about how to make sure you are on the right path.

I am posting this because right now volatility seems to be picking up into the election. And over the next two months, I worry that a lot of investors are going to feel spooked. You’re going to hear a lot of opinions about what is going to happen. And markets could, indeed, go down. That’s always a possibility. That’s the inescapable reality of being an investor. But, our approach is to stay the course in turbulent times and be patient. As unique as today’s challenges are, there were unique challenges before. Markets prevailed.

10 Rules for Playing Defense in Investing

Stocks take the stairs up and the elevator down. When they rise, it is slow and steady, but when they go down it feels like a free-fall. Given the recent market tumult, I wanted to share my top ten rules for defensive investing.
Defense doesn’t mean that you won’t have losses on days when the market goes down. It means that you avoid unnecessary risks that could really blow up your portfolio, so you can have the confidence to stay with the plan.

1. Diversification is the only free lunch in investing. You should be diversified by company, as well as by sector and country. If your employer issues you stock options or has an Employee Stock Purchase Plan, take every opportunity to sell and diversify elsewhere. Most disaster stories I hear are from people who failed to diversify.

2. Index Funds are the antidote to performance chasing. When you pick a concentrated fund, such as a sector fund or single country fund because of its recent track record, you risk buying at the top and experiencing a painful (and much larger than necessary) drop when the winds change direction. While it’s so easy to find actively managed funds that beat the index over the past year, there is a better than 80% chance that those funds will lag the index over the next five or more years. The Index fund is also likely a fraction of the cost and is also more tax-efficient than an actively managed fund.

Read More: Manager Risk: Avoidable and Unnecessary

3. Asset Allocation is the most important decision you make. Start with a carefully measured recipe so you don’t end up with a random collection of funds and stocks you’ve acquired over the years. If you’ve decided that a 60/40 portfolio is the right mix for your needs, that should be for all market environments, not just while stocks are going up.

4. You are going to be tempted to adjust your Asset Allocation. It is very tough to get this right, because humans are wired to make terrible investing decisions. We want to sell a down market and we want to buy when the market is at all-time highs. Obviously, in hindsight, we should buy when things are really ugly and sell at the peaks. Invest with your brain and not your gut-feeling.

Read More: Are You Making These 6 Market Timing Mistakes

5. Rebalance. When you have a target asset allocation, then the process of rebalancing back to your target levels creates a built-in process of selling assets which have shot up in value and buying assets which have temporarily gone out of favor. This works great with Funds, but don’t try this will individual stocks.

6. We buy stocks for growth and bonds for income and safety. When you try to switch those objectives, things seldom go as planned or hoped. Buying stocks for their yield and safety can easily lead to long-term under performance. Many times you will be better off in a plain vanilla index fund than a basket of super-high dividend stocks or supposedly safe stocks. Many high-yielding stocks are very low quality companies with no growth. When they do eventually cut their dividends, the shares plummet.

Similarly, you can find bonds that as quoted, should yield stock-like returns. Stay away. These could be future bankruptcies.

Read More: Bonds for Safety in 2019

7. Don’t use margin. Keep cash on hand. If you don’t thoroughly understand options, avoid them. Don’t buy penny stocks or stocks on the pink sheets.

8. Dollar Cost Average in every account you can. 401(k) accounts are ideal. You will often make most of your gains on the shares you purchased in a down market, you just won’t know it until later. 

9. Take your losses. Don’t play the imaginary game of “I will sell it when it gets back to even”. If you are in a crummy fund, replace it with a more appropriate fund. We tax-loss harvest in taxable accounts annually and immediately replace each sale with a different fund in the same category (large cap value, emerging markets, etc.). 

Read More: Why You Should Harvest Losses Annually

10. Stick to the Plan. Don’t make abrupt, knee-jerk changes. Investing adjustments should not be all in/all out decisions. Keep opening your statements, but recognize that a bad day, month, quarter, or year doesn’t mean that anything is wrong with your plan. Of course, if you didn’t start with a plan, that’s another story.

We genuinely believe that no one can repeatedly time the market and that the attempts to do create significant risk to your long-term returns. I try to convey this message consistently. Last week, a friend asked if all my clients were panicking about that day’s drop. And I said that I hadn’t gotten a single call that day, because they know we are in it for the long haul and have already positioned their portfolio with their goals in mind. 

It will not surprise you that I think you are more likely to be a successful investor if you work with an advisor who can make sure you start with a plan, stick to an asset allocation, and implement your plan with sensible investments. Along the way, we will rebalance, make adjustments, and monitor your progress. We are looking to help more investors in 2019 and would welcome an opportunity to discuss how our approach could work for you. 

The Persistence Scorecard

As investors begin reviewing their year-end 2018 statements for their 401(k) and other accounts, I know many will want to change funds after a disappointing year. What do investors do? If they have 15 funds available in their plan, they will often sell out of their lagging fund and put money into whichever funds are performing best.

It seems rational enough to believe that a fund manager who is doing well might have above average skills, work harder, or have a better team than other fund managers. That’s why many investors switch funds – in the assumption that an excellent track record is evidence that strong performance will continue. 

You should care about your funds and their managers. But the reality is that switching funds for better performance is not a slam dunk. In December, Standard and Poor’s released their semi-annual Persistence Scorecard. I hope you will read this report. It may change how you invest, how you select funds, and the reasons why you would switch from one fund to another.

In the Scorecard, S&P analyzes returns of over 2,000 US mutual funds, to determine whether high performing funds continue to have strong performance. They evaluate funds by quartile, with data through September 30, 2018. The top 25% of funds would be called first quartile and the worst 25% of funds would be the fourth quartile.

When you buy a fund in the top quartile, what is the likelihood that it will stay a top performer? Let’s go back to September 2016 and track the 550 domestic equity funds that were in the top 25% for the preceding one-year period. Only 21.09% of the top quartile funds stayed in the top quartile in the next year, ending September 2017. And only 7.09% of the 2016 top quartile funds managed to stay in the top quartile for both 2017 and 2018. Of the funds in the top 25% in 2016, only one in thirteen would stay in the top quarter for the next two years.

When you buy this year’s top funds, it is very unlikely that those funds will continue to be the best performers in the subsequent years. Even though we have all heard that “past performance is no guarantee of future results”, everyone still wants to buy the 5-Star fund, even though all that rating tells us is the fund’s most recent performance!

Perhaps you knew better than to put much weight on one year performance. Still, wouldn’t a good manager be able to create a nice long-term track record? The Scorecard also looks at three and five-year returns.

Let’s consider the five-year data:

We will go back to September 2013 and track the 497 funds which were in the top quartile for five-year performance. How did they do over they following five years, through September 2018?

Only 27.16% would stay in the top quartile for another five years. 21.73% would fall to the second quartile, 20.32% would fall to the third quartile, and 21.13% would end up in the bottom quartile. Additionally, 9.46% of the top funds in 2013 would not even exist five years later. Fund companies merge or liquidate their worst performing funds to make their track records disappear. That’s right, when you go on Morningstar and look up funds, what you see is the result of Survivorship Bias. The record has been cleansed of the worst offenders and you only see the survivors. Thankfully, S&P keeps all data and includes deleted funds in its study.

To me this is another reason to use index funds rather than active managers. There is little evidence that when you pick a top performing manager that he or she will persist as a top performer. In fact, there is about only a one-in-four chance a top fund will remain in the top quartile. That’s pretty much a roll of the dice. Switching from one active manager who is underperforming to another active manager who was recently outperforming is very unlikely to be a successful strategy.

Instead of focusing on manager selection and risk chasing performance, we take a more structured approach:

1. Start with the overall asset allocation. Your weighting of stocks and bonds (60/40, 70/30, 50/50, etc.) is the largest determinant of your portfolio risk and return in the long run.

2. Determine how much you want in each category, such as US Large Cap, US Small Cap, US Value, International, Emerging Markets, etc. We base this on correlation, risk and return profiles, and diversification benefits. Then, we adjust the weightings towards categories which we feel are presently undervalued relative to the others.

3. Choose funds which closely reflect those categories. If you are buying a mid-cap fund, it should act like a mid-cap fund. 

4. Expenses matter. According to research from Morningstar: “the expense ratio is the most proven predictor of future fund returns.” We prefer funds with low expenses so you can keep more of the performance you are buying.

5. While we could use actively managed funds, we like the track record of index ETFs, along with their low cost, tax efficiency, and transparency. They are great building blocks for a portfolio.

Being diversified means owning a broad basket of holdings. This can be frustrating sometimes, wondering why you own A instead of B, when A is down this year and B is up. But putting all your money into whichever category or fund is doing best at any one point in time is not an effective strategy. That’s not just my opinion – look at the data from Standard and Poor’s Persistence Scorecard and I think you will reach the same conclusion. Bet on the market, not the manager.

Manager Risk: Avoidable and Unnecessary

You can choose between two funds, A or B. If Fund A has an 85% chance of beating Fund B over five years, would those be good enough odds for you to want to pick Fund B?

More and more investors are realizing that using active equity managers is a bad bet. This is Manager Risk, which is the risk that your portfolio fails to achieve your target returns because of the active managers you selected. When there is a significant probability that a manager lags an index fund and only a small chance that a manager beats that index, taking that risk is going to be a losing proposition for the majority of investors.

Here are three ways Manager Risk can bite you:

1. Performance chasing doesn’t work. Top funds often have a good story about their “disciplined process”, or “fundamental research” approach, but there are so many reasons why today’s leader is often tomorrow’s laggard:

  • Massive in-flows of cash into popular funds make it more difficult for managers to be nimble and to find enough good investment ideas to execute.
  • It’s possible that the fund’s specific approach (style, size, sector, country, etc.) was in-favor recently and then goes out of favor.
  • With thousands of funds, some are going to be randomly lucky and have a period of strong performance that is not repeatable or attributable to skill.

2. The data is clear: over a long-period, the vast majority of funds do not keep up with their index. According to the Standard and Poors Index Versus Active (SPIVA) report: 84.23% of large cap funds failed to keep pace with the S&P 500 Index over the five-years through December 29, 2017.

If 17 out of 20 large cap funds do worse than the S&P 500, why do people bother trying to pick a winning fund, instead of just investing in an Index Fund? I think some of it is that over shorter periods, it can be pretty easy to fund funds that are out-performing and people mistakenly think that recent leaders are going to continue their winning streak.

Consider, amazingly, that nearly 85% of Small Cap Growth funds did better than their benchmark in 2017 according to SPIVA. What a great environment for active managers, right? They must have a lot of skill! But let’s look back further: over the past 15 years, 98.73% of those Small Cap Growth funds lagged their index. That is the worst performance of any investment category in the SPIVA report.

If your odds of outperforming the index over 15 years is only 1 in 100, you’d be crazy to bet on an active manager. It’s a risk that isn’t worth taking.

3. In some categories, there are 10-20% of managers who do outperform the benchmark over five or more years, which means that there might be dozens of funds which have done a nice job for their shareholders. Why not just pick one of those funds?

Standard and Poors also produces The Persistence Scorecard, which evaluates how funds perform in subsequent periods. Let’s look at two five year periods, in other words, the past 10 years. Imagine that five years ago, you looked at the top quartile (the top 25%) of all US Equity funds. How did those top funds do over the next five years (through December 2017)?

25.34% remained in the top quartile
21.56% fell to the 2nd quartile
18.87% fell to the 3rd quartile
23.45% sank to the bottom quartile (the worst 25% of all funds)
10.24% were liquidated or merged, which is the way fund companies make their lousy funds’ track records disappear.

So, if you picked a top quartile fund, you had about only a one-in-four chance (25.34%) that your fund stayed in the top quartile (which is no guarantee that you outperformed the index, by the way). But, you had a one-in-three chance (33.69%) that your fund fell to the bottom quartile or was liquidated and didn’t even exist five years later. Again, those are not odds that are in your favor.

This is why fund companies are required to state, Past performance is no guarantee of future results. We can look backwards at fund history, but that information has no predictive value for how the fund will perform going forward.

It’s an unnecessary risk for investors to use actively managed funds. And that’s why I have moved away from trying to pick 5-star actively managed funds, and have embraced using Index funds.

From time to time, you may hear, “this is a stock picker’s market”, because of volatility, or concentrated returns, or whatever. Don’t believe it. Even when active managers are able to have a good month, quarter, or year, the vast majority remain unable to string together enough good years in a row to beat their benchmark.

There’s enough risk in investing as it is. Let’s reject Manager Risk and instead recognize that an Index Fund is the most likely way to beat 80, 90% or more active funds over the long-term.

Stop Trying to Pick the Best Fund

So much attention is paid to picking “the right fund” or “the best fund” by investors, but in my experience, this question has little bearing on whether or not an investor is successful in achieving their goals. In fact, I don’t even think fund selection is in the top 5 factors for financial success. There are so many more important things to consider first!

1) How much you save. If you contribute $500 a month to your company 401(k) and your colleague contributes $1,000 a month, I would bet that they will have twice as much money as you after 10 years, regardless of your fund selection process. Hot funds turn cold, so most investors just average out over time. Figuring out how to save and invest more each month will get you to the goal line faster than spending your hours trying to find a better fund.

2) Sticking with the plan. Your behavior can have a greater impact than your fund selection. Many investors sold in 2009, incurring heavy losses and then missing out on the rebound in the second half of the year. Trying to time the market is so difficult that investors are better served by staying the course rather than trying to get in and out of the market.

I know that people think they are being rational about their investments, but what usually happens is that we form an opinion emotionally and then find evidence which corroborates our point of view. This is called confirmation bias. Better to remain humble and recognize that we don’t have the ability to determine what the future holds. Buy and Hold works, but only when we don’t screw it up!

3) Starting with an Asset Allocation. People may spend a vast amount of time picking a US large cap fund, but then miss out on the benefits of diversification. Other categories may outperform US large cap stocks. I recently opened an account for a new client, whose previous advisor had him invested in 180 positions – all of which were US large cap and investment grade bonds. No small cap, no international equities, no emerging markets, no floating rate bonds, no municipal bonds, etc.

The most important determinant of your portfolio return is the overall asset allocation, not which fund you chose! Our process begins with you, your goals, timeline, and risk tolerance to first determine a financial plan, including an appropriate asset allocation. The asset allocation is really the portfolio and then the last step is to just plug in funds to each category. Funds in each category perform similarly. If it’s a horrible year, like 2008, in US large cap, that fact is more significant than which large cap fund you chose.

A famous, and controversial, 1995 Study found that 95% of the variability of returns between pension funds was explained by their asset allocation.

4) Not chasing performance. The problem with trying to pick the best fund is that you are always looking through today’s rearview mirror. There will always be one fund that has the best 5, 10, or 15 year returns. There are always funds which are doing better than your fund this year. But if you buy that new fund, you may quickly become disappointed when the subsequent returns fail to match its “perfect” track record.

So then you switch to another new fund. And like a financial Don Juan, the performance chaser is quick to fall in love, but just as quick to move on, creating a tragic, endless cycle of hope and failure. If you are investing for the next 30 years, changing funds 30 times does not improve your chances of success! By the way, if you exclude sector funds, single country funds, and other niche categories from your portfolio, you will be well on your way to avoiding this pitfall.

5) Setting Goals. If you have a goal or large project at work, you probably create a plan which breaks that goals down into a series of smaller steps and objectives. Unfortunately, very few people apply the same kind of discipline, planning, and deliberate process to their finances as they do to their career and other goals. When you begin with the goal in mind, your next steps – how much to save, how to invest, what to do – become clear.

Bonus, 6) Doing what works. Why reinvent the wheel or take on unnecessary risk? We know that 80% or more of actively managed funds lag their benchmarks over five years and longer. With 4 to 1 odds against you choosing a fund that outperforms, why take that risk at all? Even if you get it right once, do you realize how small the possibility is that your choice will outperform for another five years? Better to stick with Index Funds and ETFs. Besides the better chance of performing well, you will also start with very low expenses and excellent tax efficiency. When you use Index funds, it frees up your mind, time, and energy to focus instead on numbers 1-5.

Choose your funds carefully and deliberately because you should plan to live with those funds for many, many years. There are genuinely good reasons for changing investments sometimes and we won’t hesitate to make those trades when necessary. But on the whole, investors trade way too much for their own good. The grass is not always greener in another fund!

Are Smart Beta ETFs Right for You?

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Over the past several years, you may have heard about “Smart Beta ETFs”. Today, we will look at this concept and share some very important caveats that investors should know before they purchase a Smart Beta ETF for their portfolio. While the name sounds like it would