When To Change Mutual Funds

by

Jack Piazza
Sensible Investment Strategies

One of the most frequent investor questions is when to change a fund -- note that for purposes of this article, this does not refer to periodic rebalancing of an asset allocation plan or selling a fund that has achieved a specific purpose (e.g., education or any other situation where a goal has been achieved). Changing a fund in this context is associated with either a significant shift of investor objectives or dissatisfaction with the performance of a fund.

Changing a fund can be affected by the following circumstances: (1) a major change in return objectives, time horizon and/or risk tolerance -- including lead management changes; (2) fund underperformance; (3) inappropriate fund for a desired strategy.

 Change in Objectives and Preferences 

An effective plan consists of an appropriate strategy, including detailed asset allocation by fund category, and suitable mutual funds which fit the desired strategy. To create an appropriate strategy, first identify various investment objectives and preferences -- these consist of return objectives (growth, balanced or income-oriented), time horizon (short, intermediate or long-term) and risk tolerance (aggressive, moderate or conservative).

A change in any of the aforementioned criteria will definitely affect the asset allocation percentages of an existing plan. In addition, changes in time horizon or risk tolerance will most likely necessitate existing fund replacement with different fund categories. The following summaries various scenarios:

• If return objective is the only change (with time horizon and risk tolerance staying the same), then asset allocation percentages would change in the majority of cases -- new fund categories may be added or some existing fund categories may be deleted, depending on the basic allocation change (e.g. 65% stock funds/35% bond funds to a 50/50 stock/bond allocation).
  
  

• If time horizon changes, both asset allocation percentages and fund replacement would be in order for the vast majority of existing funds, regardless of return objectives and level of risk tolerance.
  
  

• If risk tolerance changes, both asset allocation percentages and fund replacement for some existing funds would occur. More funds would be replaced if return objectives were also changed along with the risk tolerance.
  
  

• Significant increases in the asset size of the portfolio would likely necessitate only the addition of a different fund category with subsequent minor adjustments in overall asset allocation percentages. Provided objectives and preferences have not changed, changing an existing suitable fund within an appropriate strategy is usually unnecessary when portfolio size increases.
   

• Under ideal conditions, a good fund will adhere to its objectives with the same long-tenured management. However, when a lead manger departs, it is vital to verify that the new manager (1) has a good track record in managing funds with similar objectives, (2) will maintain a similar management style and (3) preferably has been in the existing management team for a few years. However, if the new manager has either limited or no experience to the funds specific objective style, you should probably investigate another fund that has similar objectives with better management performance.

 Fund Underperformance 

A frequent reason for changing a fund is disappointing performance. Nearly everyone has experienced this at some time, whether due to (1) mediocre market conditions, (2) unreasonable expectations or (3) poor fund performance in good market conditions. The key to judge fund performance is comparing it to relevant category benchmarks.

• When a fund is affected by poor to mediocre overall market conditions, usually the majority of fund categories are also adversely affected -- investors should not be too quick to "pull the plug" on a fund when overall market performance is unfavorable. Investors should review their level of risk tolerance in this situation to determine whether they can tolerate the volatility over the desired time horizon; for further risk tolerance details, see "The Role of Risk in Mutual Fund Strategies".
  
  

• An example of unreasonable expectations would be a fund that had a high double-digit return in the preceding year with investors believing that the performance can be sustained; it rarely works out that way -- investors should realize the danger of chasing hot performance and re-examine whether this type of fund belongs in their strategy.
  
  

• Poor fund performance in good market conditions is very frustrating. Investors should first review that the fund category is suitable for their appropriate strategy, then examine performance of the fund compared to the category's benchmark, average and rank. If the fund is performing below both the category benchmark and average over the previous two years, then it is time for a change -- especially if the fund is the lower third in category rank. Ideally, a fund should be ranked in the upper third of its category rank for three, five and ten years. Realistically, a fund that ranks in the upper half of it category in these time periods should produce satisfactory performance. Note that one year (or less) is not enough time to sufficiently gauge fund performance for the long haul -- all funds have periods where they underperform the overall market.
  
  

• Be aware of any changes in the fund objectives (e.g., switching from predominately large-cap to mid-cap holdings) or changes in fund managers. If a mutual fund significantly changes its objectives, then this could over-weight a category which would unnecessarily increase risk in the desired strategy and imbalance the portfolio.

 Inappropriate Fund 

Often investors have a fund which is either (1) not suitable for their risk tolerance or return objectives or (2) over-weighted compared to the other funds in the portfolio. Unsuitable funds possess volatility characteristics that run counter to investor risk tolerance preferences. Over-weighted funds are funds that may be appropriate for the portfolio, but they account for much larger allocations than optimum asset allocations; in high-risk funds, over-weighting can subject the portfolio to a higher degree of volatility than is necessary. For further details on the risk of inappropriate funds, go to "Three Common Mistakes in Mutual Fund Investing".

• Unsuitable funds should always be changed to funds that reflect the appropriate asset allocation strategy.
  
  

• Over-weighted funds should be rebalanced to restore both optimum allocations and effective diversification.

In conclusion....when changing funds: (1) adhere to the principles of an appropriate asset allocation strategy, suitable fund selection and effective diversification; (2) allow sufficient time to evaluate the performance data.

Finally, be aware of the tax ramifications in a taxable account when changing a fund -- minimizing taxes is a consideration, nevertheless the primary objective is to own a suitable fund that provides a good fit for your portfolio strategy.