In this post, let us discuss mutual fund exit strategies. In particular, the oft asked question, "when should I exit an equity mutual fund".
It is obvious that in order to know when to get rid of a mutual fund, one should know how to review a portfolio of fund holdings. In an earlier post on this topic - How to review a mutual fund portfolio - I had mentioned the importance of having personal benchmarks and how laggards can be identified with it. My focus on that post was on how to get rid of funds in the same category by considering the net XIRR of the equity portfolio.
In this post, we assume the presence of a minimalist portfolio where the position of each fund is unique and discuss exit strategies.
Be it selecting a new fund for your mutual fund portfolio, or reviewing an existing fund, there are multiple solutions and choosing one is entirely subjective. What follows below is, 'what I do'. My only qualification for writing this is that I can justify my process to myself.
(I) Actively managed mutual funds are difficult creatures to compartmentalize. Each fund house and each fund management team has a different strategy. Some funds may churn their portfolios inside out each year. Some funds may hardly buy/sell. These decisions could be independent of size/inflows. It could just depend on the fund management style or conviction, depending on market outlook.
So expecting an equity fund to beat the benchmark each year and/or beat most of the peers in its category is downright immature. I give my fund managers a lot of rope. Depending on market conditions, I am willing to waiting anywhere between 3-5 years to produce alpha (beat the benchmark)
Alpha can be created literally overnight. Equity investing is, for the most part, a waiting game. We need to stay in the market when it is going nowhere, periodically increasing our capital and wait for the big jump. Returns come in large chunks to those who patiently wait. As long as my goals allow me to wait, I am more than willing to wait patiently.
(II) Never listen to analysts or take star ratings seriously. The most important lesson from the recently published Dollar Cost Averaging aka SIP analysis of S&P 500 and BSE Sensex was that equity returns depend on when you start investing. The same thing applies to when you start analyzing a fund. The return you register, would be very different from what star ratings software records. It is like three blind men touching an elephant.
I currently hold a two-star fund with a XIRR of 23%. It would be childish to assume that such a return is inadequate and that I am missing out by not exchanging it with a five-star fund.
(III) Over the years, I have come to appreciate the importance of "doing nothing" (not sure who coined that first). Today the net XIRR of my retirement portfolio is 18.7% after 8 years of investing. I am more than happy with it. If I can report the same number after 5-6 years, I would be financially free.
About 88% of my mutual fund holdings have individual XIRRs above 18.7%.* I see no reason to exit the 12% of holdings which have below 18.7% XIRR. Even if it was a considerably higher number (and it was for a pretty long while), I would not have done anything. I recognize the need to wait.
(*) XIRR depends on time as well as investment amount.
The point is, even with a personal benchmark as net portfolio XIRR, one need not, and I think should not, act immediately if there are some funds with low returns. It could be temporary. About 6 months ago, the difference between the net XIRR and the lowest fund XIRR was close to 12%. Today is only 3%. Doing nothing helps ... a lot.
(IV) If I am convinced that a change is necessary and that I must exit a fund, I must analyze its performance with its benchmark for my investment duration. That is, since the time I have held the fund. There are a few tools here which can help you analyze this:
Determine how consistently the funds lump sum returns have beat the benchmark return with this: Multi-index Mutual Fund Rolling Returns Calculator
Determine how your SIP has fared month on month with this: Mutual Fund SIP XIRR Tracker
In addition, you can also perform an year on year risk adjusted performance analysis:
or for different investment duration:
In addition, I must also see if there are changes in the fund management, investing style while always keeping in mind the current market conditions.
I will worry if the investing style has changed whether the performance is 'poor' or not. Here 'poor' is pretty subjective. I think being reasonable always helps.
If the fund manager has changed and the onset of the poor performance coincides with the exit, it is perhaps a warning sign. However, I think one must give the new management reasonable time to perform.
Again 'reasonable time' is subjective!. Take the case of Reliance Growth: Mutual Fund Analysis: Reliance Growth Fund
Between June 2008 and Feb 2014, the fund behaved like an index fund. So I said, 'exit'. After a couple of months, it had set a record NAV of Rs. 700 per unit! So these things are difficult to call. I do stand by my 'exit' call. I think Reliance Growth had trouble handling the sudden inflow due to its popularity.
If the fund we are investing in, gets popular suddenly, I think it is a warning sign. It if is a large cap or large and mid-cap fund, the need to worry is perhaps lower, unlike a mid and small-cap fund. Still, I think the management should be given a, er.. reasonable amount of time!
Sometimes during a prolonged bear market, the manager may decide to stand by his/her picks. If that is the case, the investor will have to wait, but there is no way of knowing this, unless we can speak to the management.
(1) Give your fund a lot of rope.
(2) Analyze performance only for your investment duration and not any period shorter or longer
(3) If there is sustained under-performance, see if the cause can be determined (new management, sudden inflows, prolonged bear market etc.)
(4) Take a call to stay put or exit. No matter what you do, do not regret. Focus on the grown of your goal corpus and not return.
(5) Do not compare your return with others.
(7) Do not listen to people who say 'there is a better way', without proof. The financial services industry thrives on portraying mutual fund investing as rocket science.
(8) Trying to maximize returns by mindlessly changing funds is downright silly.
(9) Review the portfolio once a year. A review does not mean you should change funds!
Also see: How to Review Your Mutual Fund SIPs
What do you think?