When To Change Mutual Funds?

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Written By Mark

Mark is the co-owner of RetiringStrategy.com and has many years of experience in financial markets. 

Many investors want to know when to change their mutual fund. For purposes of this discussion, the consideration of when it’s appropriate to change funds doesn’t refer to selling a fund when it achieves its specific purpose, e.g. paying for educational expenses or any other scenario after the goal is achieved, or periodic rebalancing of your asset allocation plan.

The consideration of when to change a mutual fund investment, in this context, reflects dissatisfaction with the fund’s performance or a shift of your investment objectives.

When to Change Your Mutual Fund?

You may wish to change a mutual fund investment in any of the following conditions, e.g. (1) the fund seems inappropriate for your desired investment strategy, (2) you made a significant new decision regarding your risk tolerance, return objectives, or time horizon, or (3) the fund has underperformed relative to expectations.

The Mutual Fund is Inappropriate to Your Investment Strategy

If you find that a fund is either (1) unsuited to your risk tolerance profile or return objectives, or (2) the fund position is overweighted when compared to other mutual funds in the portfolio, it’s important to remedy the situation:

An unsuitable fund may have volatility characteristics that aren’t in line with your risk tolerance preferences. 

An overweighted fund is one that’s potentially appropriate for your portfolio, but it represents a larger than optimal portfolio allocation.

If a high-risk fund is overweighted, this can expose the portfolio to more than necessary volatility. To learn more about the risk of holding inappropriate funds, refer to Three Common Mistakes in Mutual Fund Investing.

Change out any unsuitable funds to reflect your current asset allocation strategy. Rebalance any overweighted fund to restore effective portfolio diversification and appropriate allocations.

Change in Your Investment Objectives and Preferences

An effective investment plan includes

  1. an appropriate investment strategy, including a detailed asset allocation according to fund category
  2. mutual funds which match the desired investment strategy
  3. true diversification of what you own, including hard assets like gold (see 20 reasons to invest in gold) and other precious metals. See our guide on how to rollover a 401(k) plan to a physical gold IRA for more details.

To prepare an appropriate strategy:

Identify your investment preferences and objectives, e.g. return objectives (growth, balanced income plus growth, or income-oriented), time horizon (short-, intermediate-, or long-term), and risk tolerance profile (aggressive, moderate, or conservative).

Any change to the above criteria will certainly impact the asset allocation percentages in an existing portfolio plan.

What’s more, changes in your risk tolerance profile or time horizon will probably require you to replace funds.

The following summarizes a variety of scenarios, including:

Return Objective is the Only Change

If the time horizon and risk tolerance profile remain the same, your asset allocation percentages will probably change most of the time.

You may add new fund categories or delete existing fund categories determined on the allocation change, e.g. shifting from 65 percent equity funds and 35 percent bond funds to an equal equity and bond fund allocation (50/50).·

Time Horizon Changes

If your time horizon changes, asset allocation percentages, as well as fund replacements, will occur in most cases, regardless of your risk tolerance level and return objectives.

Risk Tolerance Changes

If there’s a change in your risk tolerance profile, both asset allocation percentages, as well as fund replacement for some funds, are likely to occur. More funds must be changed if your return objectives change along with your risk tolerance profile.

Increased Portfolio Asset Size

If the asset size of your portfolio significantly increases, it’s likely you will need to add fund categories. This is likely to require some minor adjustments to your asset allocation percentages.

If your preferences and objectives remain unchanged, choosing a suitable fund within the appropriate strategy is often unnecessary in this scenario. Ideally, a good fund adheres to its stated investment objectives and remains in the hands of long-term managers.

However, if a head portfolio manager leaves, it’s essential to know that the new manager (1) has a reliable track record of managing funds with like objectives, (2) will execute and perform similarly to the exiting manager, and (3) has worked with the management team for a reasonable time. 

Consider changing the fund when a new manager has limited or no experience in managing a similar Objective-style fund. In this scenario, identify another fund with similar objectives and management performance.

Fund Underperformance

A disappointing performance in your mutual fund can prompt you to consider its replacement. Nearly every mutual fund investor has experienced disappointing fund performance due to (1) poor returns in good market conditions, (2) unrealistic expectations, or (3) mediocre market conditions.

Since you can’t control market volatility or lack of it, compare your fund’s performance to relevant benchmarks in its fund category. Don’t pull the plug when the broad markets show poor or mediocre performance.

Assess your risk tolerance profile to discern whether you can tolerate volatility over any desired time horizon. Refer to The Role of Risk in Mutual Fund Strategies to learn more about risk tolerance.

Unreasonable Expectations in a Mutual Fund

Let’s say you own a mutual fund that delivered high double-digit returns last year. It’s not unreasonable to hope for the same this year but, unfortunately, mutual funds rarely perform in this way. 

For this reason, never chase hot performance. Avoid acquiring into last year’s highest returns in a fund category. Ask whether this kind of fund belongs in your strategy.

Poor Fund Performance In a Good Market

A poorly performing fund in good market conditions is frustrating. Start by analyzing the fund category. Is it suited to your appropriate strategy? Then, consider the fund’s performance relative to the category benchmark (rank and average).

If the fund is underperforming both average and category benchmarks for the prior two years, consider changing the fund. If your fund ranks in the lower third of its category, it’s probably time for a change. Consider the following performance criteria:

Your fund ranks in the top third of the category over the past three, five, and 10 years.

If your fund ranks in the top half of the category over three, five, and 10 years, your position should produce acceptance performance.

One year, or less than one year, is an insufficient time period in which to judge your fund’s performance over the long term.

All funds may have periods in which they underperform the broad market.

Note whether your fund objectives change, e.g. shifting from large-cap to mid-cap stocks, or the fund managers change. A change in your fund’s objectives can unwittingly create an overweight position in a category. This scenario unnecessarily increases your risk and imbalances your portfolio.

When Changing Mutual Funds: our final words

Most mutual fund investors will change funds at some point over the years. It’s essential to adhere to the standards of your asset allocation strategy once it’s determined.

It’s essential to find and retain suitable funds, effectively diversify the portfolio, and allow for enough time to pass to evaluate your performance.

Lastly, be aware of the impact of taxes when you change a fund in a taxable account. While your primary objective is owning suitable funds that fit into your portfolio strategy, it’s important to consider taxes in overall portfolio performance.

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