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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.

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