When should you sell your mutual funds?

When a fund underperforms for a few months or quarters, you shouldn’t exit in a hurry.

Investors spend a considerable amount of time picking the best funds. But generally, they are not very clear about how and when to exit/sell the same funds. More often than not, they end up not exiting, at times citing diversification. This leads to a cluttered portfolio — a ‘zoo’ of different funds.

While regular and unnecessary churn is best avoided (as it leads to frictional costs in the form of capital gains taxation), it is still important to know when to exit a fund. You cannot neglect your exit strategy just to avoid paying taxes. Taxes are a reality of life, so you need to optimise your strategy for taxes.

Here is how to go about deciding when to exit your mutual funds.

Exit due to fund under-performance

This is the most common reason to exit a fund. But arriving at the conclusion that your fund is not doing well is not that simple. While a fund not doing well for a few months or quarters is common, you shouldn’t be in a hurry to exit such funds. It is not rare for good funds to undergo short-term underperformance. Only when the underperformance continues for a long enough period, say 1-2 years, compared to its benchmarks and peers, and that, too, by a decent margin (a few percentage points, at least, consistently), should you consider exiting.

Also, you must give weightage to the investing style of the fund. All investment styles (value, growth, etc.) will have periods when they are not doing well. But that is exactly what is supposed to happen. No investment style works all the time. It’s a feature, not a bug. Rather than getting disheartened with the recent underperformance of any particular style and then exiting such funds (to switch styles), be willing to choose a style that you can stick with through all cycles. Be ready to give a few years to a style and the funds you choose.

Also see: List of top funds - MC30

Exit once you reach your goal

Suppose you had a financial goal to save Rs 40 lakh for your daughter’s graduation by 2025. Thanks to the run-up in equity markets, you have already reached Rs 43 lakh a few years early. And your current allocation is 63 percent to equity and 37 percent to debt. Your goal therefore has already been achieved before time.

This should be one reason to consider reducing risk (equity allocation) and exiting some equity funds. Mind you, this is not because of fund-related issues, but because of asset allocation and prudent risk management. As highlighted in the article Move to a safer option if you reach your goals early, you need to avoid the risk of a bad sequence of returns and reduce your equity allocation.

If you have less than three years left to reach your goal, then it’s best to redeem and reinvest primarily in debt instruments, with lower risk and predictable returns. Money growing at a lower rate is fine, as you have already achieved your target and have the option of meeting your goal without exposing the accumulated capital to any further risk. Doing this is especially critical for important goals like your children’s higher education, retirement, etc. as these are non-negotiable.

Exit funds to rebalance your portfolio

Let’s say you have a long-term goal for which the chosen asset allocation is 60:40 equity:debt. After a few years of regular investing, your goal-related portfolio becomes Rs 25 lakh with Rs 18 lakh in four equity funds. i.e., allocation of 72 percent to equity.

Now, to rebalance your portfolio back to 60% equity, you need to sell a portion of your equity fund holdings. You can pick one of the four equity funds that you hold for the rebalancing. How you pick this one fund will depend on performance.

Or you can sell a portion of the fund that has an uncomfortably high concentration in your overall equity MF portfolio (say it has a 47 percent allocation in the above 72 percent equity allocation).

Or if you have multiple schemes from the same category and they are overlapping, you can exit a scheme or two to reduce the overlap and have just one fund per category.

Exit active largecap funds, switch to index funds

Most active largecap funds are now lagging behind their benchmarks and are finding it tough to consistently beat their passive counterparts. So, there is now a case to gradually, if not immediately, exit active funds in the large cap category and instead switch to passive largecap index funds.

Other reasons

While we have looked at the primary reasons to exit equity funds, there are many other reasons that can trigger a sell decision.

• When there are changes to a fund’s stated mandate due to restructuring of schemes, etc.
• When the fund manager changes and you are not sure about the new one’s ability to keep the ship running.
• When there is a merger of AMCs and the funds you hold are impacted (rejigged to suit AMC merger requirements).
• When you choose to exit funds that have a very small allocation in your portfolio and you do not intend to increase their weightage.