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The Error-Proof Portfolio: 4 Bad Reasons to Sell a Fund

Performance, especially, can lead investors to sell funds that they should have hung on to.

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The decision about whether to sell a fund is usually not clear-cut, even in hindsight.

After the dust has settled on a decision and the investment has performed well or poorly, the "right" answer is wholly dependent on the individual.

Take  Fairholme Fund (FAIRX), for example. The concentrated fund's streak of winning performance following its inception at the end of 1999 earned manager Bruce Berkowitz Morningstar's Domestic Equity Fund Manager of the Decade honors for 2000-09. It also prompted a rush of asset inflows toward the end of the decade.

But those newly arrived shareholders soon faced a conundrum when the fund crashed in 2011. Top holdings  Bank of America (BAC),  Sears Holdings (SHLD), and  American International Group (AIG) all tumbled more than 50% in 2011, and the fund itself lost more than 30%. Investors had to decide whether to cut their losses, in the knowledge that the fund was riskier than they had thought, or hang on in the hope that Berkowitz's conviction would pay off down the line.

To date, those who stayed put in the fund have indeed seen their patience rewarded, as returns have soared since 2011. Meanwhile, the investors who sold Fairholme may not have done so badly, either, depending on where they put the proceeds from the sale. If they let the money sit in cash, then selling was clearly a bad idea: Cash hasn't out-earned the inflation rate, while stocks have been on a roll. But if investors sold Fairholme and swapped into a milder-mannered equity fund, they no doubt obtained decent returns while also getting themselves into an investment that could be easier to live with in the future. Berkowitz, the Fairholme manager, has shown no inclination to back away from the fund's extreme stock and sector concentrations, making further performance swings all but inevitable.

As the Fairholme case illustrates, it's difficult to arrive at selling criteria that fit every investor. But there are some situations when selling is especially ill-advised. Here are four of the key ones.

Bad Reason 1: Weak Short-Term Performance
It's almost never a good idea to sell a fund based on weak performance alone, whether short- or long-term. Instead, if a fund is lagging its peers or an index, your first move should be to investigate why that is. It could be that the manager is simply sticking with an investment strategy that happens to be out of favor, as was the case with many value-leaning funds amid the tech boom of the late 1990s. Such discipline is often vindicated over time. But weak performance may be a sign that something more serious is afoot--for example, perhaps your fund is lagging in a market led by small caps and mid-caps because it's gotten too large and the manager can only put all that money to work in larger-cap stocks.

Researching an investment's fundamentals can be time-consuming, which is why you don't want to get too caught up in investigating short-term bouts of underperformance. Most funds, especially those that are using truly active strategies, will trail their peers at times, often for very good reasons and for a few years or more. (Indeed, that's been the case with some perfectly solid, defensively positioned funds over the past five years.) Instead, save your energies for checking up on funds when they've underperformed over longer stretches of time or in a period when you would have expected them to perform well. If, for example, you prized a fund because of its low-risk tendencies, but it lost far more than its peers in 2008, that's a legitimate reason to ask whether something about its strategy changed or its risk controls weren't what you thought they were. Even if the fund isn't bad, it may not be a good fit in your portfolio.

Bad Reason 2: Inconsistent Performance
In a related vein, investors often get themselves worked up when a fund's relative returns are inconsistent on a year-to-year basis. Sure, it can be comforting to see a fund land in its category's top half like clockwork--and a small handful of funds has actually managed to generate return rankings that have been remarkably consistent from year to year. ( T. Rowe Price Mid-Cap Growth (RPMGX) is one of my favorite examples.)

But holding all of your holdings to that standard would cause you to kick out some fine offerings that, while not consistent performers on a calendar-year basis, are consistent where it counts: They employ their strategies with discipline and don't waver, even if the market isn't rewarding them in the near term. It's also important to remember that a calendar year is a fairly short and arbitrary time period, and the fund that has looked erratic over January-through-December time periods may appear perfectly consistent when measured over a different 12-month time frame--say, from April through March of each year. This article delves into why investors shouldn't get too hung up on year-to-year performance consistency when deciding what to hold in their portfolios.

Bad Reason 3: Macroeconomic News
Macroeconomic news, whether it's the direction of U.S. interest rates or GDP growth in China and India, often appears right alongside news about the market's trajectory. And it's true that what's in the headlines has the potential to move the markets up or down on a daily basis, or even over longer time frames. The trouble is that by the time a certain news item makes its way into the headlines, other market participants have already digested it and priced it in. If you decide to sell your fund based on that news, you're likely to be too late. Instead, a better tack for investors, at least as it relates to their portfolios, is to keep their heads down and focus on factors that they can control: their savings and spending rates, the quality of their investment holdings, and the total costs they pay for those investments. This article provides more detail on the virtues of tuning out the noise when it comes to managing your portfolio.

Bad Reason 4: Dodging an Impending Capital Gains Distribution
When mutual funds sell holdings that have appreciated, they're required to pass through those capital gains distributions to their shareholders, who in turn must pay taxes on them. Some funds even give warnings that a distribution is on the way, prompting some investors to think about selling pre-emptively, before the fund dishes out on the distribution.

That might sound like a good plan, and it's not unreasonable in those rare cases when an investor gets socked with a distribution shortly after buying. But it's usually not a lucrative strategy for shareholders who have held a fund for any period of time and have seen appreciation in their holdings. That's because fund shareholders face capital gains taxes at two levels: First, they can be liable for capital gains taxes when their funds make distributions, and second, they can be on the hook for capital gains taxes when they themselves sell shares that have appreciated in value since they purchased them. Thus, a shareholder who sells shares pre-emptively to avoid a distribution may inadvertently trigger another, even larger tax bill on the spread between the cost basis and the sale price.

See More Articles by Christine Benz

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.