When Should You Exit From Your Mutual Fund

Exiting from your MF investment is as critical as investing in them. DSIJ analyses different situations that should prompt you to exit from a particular mutual fund scheme.




Surendra Lal Phathak, a tech-savvy investor, wanted to start his investment journey in mutual fund. He searched and went through all the websites explaining why, when and how to invest in mutual funds. After going through all this pain, he zeroed in on a couple of funds. These funds were given 5-star ratings by various MF rating agencies and had excellent past performance. He finally made investment in one of these 5-star crowned funds. For the few months, the fund continued to perform according to his expectation, however, after that, the performance was flat for a couple of months. This despite most of the market and his wife’s investment was doing fine. He shrugged this off as a temporary phenomenon as the 5-star rating was still maintained. His suffering continued as the fund kept on underperforming and he lost 20 per cent of the invested value in the next few months. He had read that MF investment gives better return in the long run and hence he was not perturbed too much by the recent fall in the value of his fund. Moreover, he was advised that time in the market is more important than timing the market. Nonetheless, after a few more months, he had lost even more despite market continuing to perform better. Finally, he could not take the fall in his investment value further and decided to sell his units and do a fixed deposit.

The ordeal of Surendra Lal Phathak may not be shared by a majority of the mutual fund investors, but there are many investors who have gone through this experience and have lost faith in investment in mutual fund. Nonetheless, barring a few incidents, there are very few instances of a sudden drop in the NAV of a mutual fund. Long before such a fall, there are warning signals that keep on appearing on the horizon which should not be ignored.

In the following paragraphs, we will talk about why following legendary investor Warren Buffet may not be the best idea. He had once said, “Our holding period is forever”.

The Warning Signals

In recent months, there have been instances in both equity as well as debt markets that have led to the serious underperformance of the funds holding these company’s instruments. You cannot do much with such stray incidences; however, in other cases, if you take corrective action at the right time, it will improve your investment experience.

The following triggers should be considered by you to stop your investment through systematic investment plan (SIP) as well as lumpsum investments.

Persistent Fall In Performance:

The first red flag you should keep an eye on is the decline in the performance of the fund. Even the best fund managers go through short-term bouts of underperformance; however, a consistent decline in the performance of the fund should be more than enough for you to take a closer look at the fund. Nonetheless, the fund's performance should be compared with its peers and benchmarks. This is important because a wrong comparison might lead to a wrong decision. For example, last year (2018), even if you had invested in the best of small-cap or mid-cap funds, chances are they would have underperformed as compared to the large-cap funds. The reason being the entire mid-cap and small-cap stocks went through a huge correction and hence all funds dedicated to these categories underperformed the large-cap funds. Such comparison with large cap funds would have led you to selling your mid-cap fund that has outperformed its category and benchmark.

Therefore, the performance of the fund should be done with a right perspective that will help you to take proper decision. If a fund is under performing its peers and benchmark for a consistent period of time, it is better to exit the fund.

High Redemption

Sometimes it helps you to follow the crowd and not your gut feeling. It might happen that you may could miss the warning signal that others could see. Therefore, huge redemptions from a fund may be a precursor to the bad performance of the fund. Not only heavy outflows, gush of inflows also have a negative impact on the investment strategy implementation and performance. Heavy outflows can force a manager to sell the holdings he would have otherwise held.

According to a study done by Morningstar of the mutual fund industry in the US, between 2006 to 2011, among the large-cap, mid-cap and small-cap (excluding US large-cap) stock funds that were seeing the most outflows, just 20% of them survived for the next three years, and out of this, only 26 per cent outperformed their respective category peers in the same period. An interesting conclusion of the study is that even the large inflows impact the fund performance adversely, going forward.

Hence, you should always look at the redemption of the funds in which you have invested. Heavy outflows give you early signal of bad performance going forward.

Higher volatility

Volatility, which is measured by standard deviation, also gives some indication of future performance of the fund. If you find the standard deviation, which measures the fluctuation of the return from its average, increasing, it is a good time to look closely at the fund. If it continues for a while, it would be prudent to exit the fund. It has been observed that heightened volatility in returns of the fund is followed by a subdued performance subsequently. In our study of large-cap funds for the year 2018, we have found that funds that have shown increase in volatility have generated lower returns in the following months.

When the investment objective of the fund changes The most logical way a fund is selected and invested is to assess whether it suits your risk-return profile and whether its investment objective matches yours. Nonetheless, many a time, MF schemes change their fundamental attributes and objectives. This is followed by change in asset allocation of the fund, which changes its risk-return profile.

Investors are given an option to exit from the fund after a change in the objective. They need not pay any exit load, but they have to pay taxes, if any. You need to check if the new objective matches with your risk-return profile and financial objective. If it does not, it is better to exit from the scheme.

Frequent churning in the top management

There is no one-to-one correlation between churning in the top management and the fund’s performance. Nonetheless, among the 5 Ps (people, portfolio, process, performance and philosophy) that determines the performance of a fund, ‘people’ remains at the top. Any change in the fund manager impacts the performance of the fund, more so if the change is quite often. It has been observed that part of the positive performance of a mutual fund is determined by how long the mutual fund manager has been managing the fund. Although, there is a very weak correlation, an increase in the management tenure leads to an increase returns of a fund. Hence, be wary of those funds whose fund managers change frequently. Moreover, many of you might be looking at the long term performance of the fund to invest in it. However, if the current fund manager has remained for the last one year, it does not make sense to look at the performance of the past five years when the current fund manager was not there. Hence, a frequent change in the management should ring a warning bell in your ears.

The factors discussed above have more to do with the fund and fund houses. You wanted to remain invested in the fund, but could not continue because of the fund-related issues. There are genuine cases when despite everything being good about the fund; you need to exit the fund.

Rebalancing your portfolio

Rebalancing of your portfolio, which is often overlooked, is one of the most important aspects of overall financial planning. While rebalancing your portfolio, you may find that a particular fund no more fits in with your plan of achieving your financial goals or it has outlived its utility. In such a scenario, even if the fund is generating better return, you may have to exit it. For example, your financial plan requires you to increase your allocation towards large-cap funds as you grow older. This is because large-caps are considered less risky. In that case, you need to redeem some of the mid-cap or small-cap funds and invest in large-cap funds.

Change in asset allocation

Many research reports suggest that asset allocation is extremely important and it is a larger contributor to your overall portfolio return. Therefore, you also go through this ritual. While doing your periodic asset allocation, you might have to exit from a fund, even though nothing has changed fundamentally about the fund. For example, according to your financial plan, your asset allocation requires you to allocate 60% of your assets in equity-dedicated funds and 40% in debt funds. In a good year like 2017, due to outperformance of your equity portfolio, your total portfolio has now 66% in equity and 34% in debt. In such a case, you need to exit from some of the equity funds (assuming no incremental investment is being made) and invest in debt funds to achieve the right asset allocation. In this scenario too, you need to exit from equity funds. It holds true even in the case of underperformance of equity funds, where you need to invest more in equity funds and redeem from debt funds.

Nearing your financial goal

Sometimes, it may happen that you are nearing your financial goal. Hence, you may want to move your investment to safer options. This might entail exiting from certain funds and getting into different funds. Normally, you invest in a fund and a goal is attached to that fund. For example, you might be investing for your child’s marriage, which is after 20 years. Since this is a goal with a long term horizon, you invest in equity funds that have historically given better returns than other asset classes. Nevertheless, these funds may become volatile at times over a shorter duration. We are currently witnessing that bout of volatility. Therefore, you start shifting your accumulated fund in safer options such as debt funds after 17 years so that the entire fund is invested in debt by the end of 20 years. So, in the above case, even if your fund is doing exceeding well, you will have to exit from the fund.

You have reached your financial goal

Continuing further on the above point, you should ideally exit from the fund after 20 years. This has to be done despite the fund where you have invested is doing well. A perfect example would be, say, your goal was achieved in the year 2017. However, looking at the buoyant market, you continued to remain invested looking for higher returns. The year 2018 would have made a big dent in your accumulated returns, and in fact, chances are high that your goal would not have been met. Since you cannot forecast the future, it is better to stick to your financial plan and exit when you have achieved your financial goal. It is better to be safe than sorry.

Consider exit load and taxes before exiting

Once you are clear about the reason you want to exit from the fund, the next step is to exit wisely. This is because there are two costs involved while you exit a fund. First is the exit load and the second is the tax.

An exit load is the fee charged by mutual fund houses when an investor sells or redeems his investment in that fund within a specified period. This charge is calculated as a percentage of the NAV at which you are exiting the fund and not on the NAV at which you had invested. Exit loads vary from scheme to scheme, but have to be within the limit prescribed by the market regulator, Securities and Exchange Board of India (SEBI). Therefore, you need to check what you will finally get in your hand. In case of investments through SIP route, each investment is taken as fresh investment and hence one year will be counted from the day you have made the investment.

The tax is imposed at the time when you redeem your money from the mutual funds. Since mutual fund investments are considered as capital assets, any gain made on sale of your MF units will attract capital gains tax, which is calculated as the difference between the NAV on the date of sale and the date of purchase. The taxation is different for equity funds and debt funds.

For equity fund, if you withdraw before one year, you pay 15% tax on your capital gains. From April 1, 2018, if you exit from the fund after one year, long term capital gains (LTCG) over Rs. 100,000 per year will now be taxed at the rate of 10 per cent without any indexation benefit. In the case of debt fund, three year is considered as long term and hence any withdrawal before three years will attract short term capital gain tax, which will be as per your tax slab. After three years, you will have to pay tax at the rate of 20% with indexation benefit.

Conclusion

Exiting from your MF investment is a part of the second leg of your financial planning. Hence, it is as important as investing in the fund. Therefore, you should plan your exit from your investments in a way that is in sync with your financial goal. Your exit should be guided by your comprehensive financial plan. Any haphazard sale of your investment for any reason, including underperformance of the fund, may potentially ruin your financial plan.