When is the best time to withdraw from a mutual fund?
After a recent stock market crash, Ian Bloom, a financial planner in North Carolina, received a terrifying call from a VIP client: his mother.
“I have to sell everything!” he said to him.
He assured her, as he does to all his clients, that if he did it he would lose much more than he would gain because they had already created a financial plan that included market sales.
Now would come the hardest part: holding on to it.
Market fluctuations can cause investors to leave their mutual funds in disdain. They may feel their money could work harder elsewhere.
That may be true. There are situations where selling mutual fund shares works to your advantage. But you can also find harmful effects.
The time to sell a mutual fund is when you need liquidity and plan to make the move, says Eric Gabor, certified financial planner and founder of Eagle Grove Advisors.
“Any market downturn or reaction to a geopolitical event is not the time to sell,” he said.
Individual investors should only sell funds when their circumstances warrant a change, says Amy Hubble, a certified financial planner and principal investment advisor at Radix Financial. He says investors need cash, or reduce risk as the need for cash looms closer.
“Or maybe your target allocation to that asset class has grown out of tolerance compared to the rest of the portfolio,” says Hubble. “For example, you had a strategic allocation of 10% and now it’s 17% of your portfolio.”
But it can be hard for investors to remember to sit on their hands when they hear bad news.
It’s not uncommon for a novice investor to want to sell their investments when they see a downturn in the market, says Leah Hadley, certified divorce financial analyst and CEO of Great Lakes Investment Management. “That’s why we work with clients to determine the right level of liquidity so that there is less temptation to sell when the market is down.”
Keep in mind that your mutual funds may hold more than just U.S. stocks, says Bloom, head of Open World Financial Life Planning.
“Your portfolio will have funds that cover different parts of the market,” he says. “Sure there’s the S&P, but there might also be bonds, international and emerging markets. When the market goes down, nobody talks about other parts, international investments, bonds. What stands out is the part in red: S&P.’
While sticking to your plan and strategy throughout your timeline, there are mutual fund red flags that may merit a switch.
“I will consider a change in portfolios if there has been a change in the fund’s strategy and it doesn’t make sense in my overall strategy with the client,” says Hadley. “Also, I will sell from a mutual fund that is consistently outperforming the relevant benchmark.”
Gabor also recommends seeing a fund manager. “If a manager leaves a fund they’ve managed for many years and a new successor is appointed, that may be the time to reassess how it fits into your portfolio.”
He added that investors should be on the lookout for tax-inefficient funds.
“If there are significant inverse tax consequences, it could come out,” says Gabor. “That’s why I like tax-managed mutual funds and exchange-traded funds.”
Beware of high turnover ratios, says Hubble, like over 25% per year. “Funds with high turnover ratios mean that the fund is managed tax efficiently and is likely to receive unannounced short-term profit distributions at the end of the year, which carry high tax costs.”
Another red flag is expense ratios. “This is the most important number to look at in a fund,” says Hubble. “Don’t pay managers more than 1% in long-term savings accounts to underperform the market half the time. Do yourself a favor and for long-term money, skip active managers altogether and invest in low-cost index funds.”
If an investor decides to liquidate the fund, take care of your tax liability.
“If the investor has held the fund for less than a year, all capital gains will be taxed at their income level,” says Timothy Kenney, certified financial planner and founder of TK Pacific Wealth. “If they’ve held onto the fund for more than a year, they might get a small break on capital gains tax, maybe 5% or 20% depending on your tax bracket, but they might have a big tax bill to pay next year. We’ve been in a bull market for so long.”
If you have a fund you’re looking to sell and it happens to be at a loss, Kenney suggests focusing on capital gains distributions.
Funds tend to pay out capital gains towards the end of the year, and by selling before the distribution, you avoid getting hit with taxes.
Have an investment question? Ask us here for inclusion in a future column.