When it comes to mutual funds, diligent investors can find plenty of information in the public domain that can help them make their investment decisions. There’s information on how to invest, when to invest, which funds to choose, how to choose funds, mutual fund risk and much more. However, there is not much to be found on mutual fund exit strategies, which generally makes this the biggest challenge for investors. Having conviction around an exit strategy becomes particularly relevant whenever the markets correct; without it, investors panic and retreat based on sentiment rather than a well-planned strategy.
Often, investors try to time the markets by exiting their investments in hopes of reinvesting at lower levels. This is a classic case of “market timing”. Also, investors sometimes tend to treat mutual funds like stocks. A stock can be undervalued or overvalued, and therefore it might be justified to exit an expensive stock vis-à-vis a mutual fund. A mutual fund, on the other hand, is a basket of investment products and the price of each unit reflects the value of the products in the basket. Therefore, the question of overvaluation or undervaluation does not arise.
Knowing how to exit a mutual fund is as important as knowing when to exit and can make or break your wealth building process. The exit of a fund should not be made according to the fluctuations of the market, except in an emergency. It has to be done in a thoughtful way, with an action plan.
Here are some instances where an investor should consider exiting the program.
1. Financial objectives achieved or close? Get out of the scheme and invest in less risky assets
When you approach your financial goal ahead of schedule, you need to focus on preserving the corpus. As you get closer to your goal, your ability to take risks decreases. Staying invested in an equity fund once the goal has been reached can sometimes be counterproductive.
If you have reached your financial goal earlier than expected, you can exit the plan and transfer your corpus to a liquid fund or even a bank fixed deposit to preserve the accumulated amount.
In any case, to protect the corpus you have amassed, when you are one or two years away from your goal, switch to less risky funds where the equity component is negligible.
2. Do you want regular income from your mutual fund investment and are looking to preserve your capital? Make a systematic withdrawal plan (SWP)
If you want steady cash flow from a mutual fund, don’t upgrade to a dividend option. It will be more effective if you follow a SWP. This is an excellent facility offered by mutual funds and it is also extremely tax efficient.
When you choose a SWP plan, it allows you to redeem your investments gradually. You can direct your mutual fund investments to your savings account. In a PRS, the value of a mutual fund is reduced by the number of units you withdraw.
Let’s look at the example given below to understand better. If you have your desired corpus of INR 1,000,000 in a fund, assuming you only redeem 7% per month (INR 5,383) for one year, the amount will be taxed as short term capital gains at 15% for withdrawals up to one year and long-term at 10% for more than one year. Also, each year the value of the fund would decrease due to withdrawals and increase/decrease due to market movements.
The total withdrawal according to this illustration is around INR 70,000 and if you had invested it in a dividend option, the tax payable would have been around INR 21,000 (assuming a 30% slice) whereas in the growth option, your capital gains tax is INR 2,500. .
3. A change in fundamentals? Revise and rebalance
When a fund undergoes a fundamental change, the risk profile also changes. This may be due to a change in fund manager, a change in the fundamental attributes of the fund, or a change due to regulatory standards.
If the fund manager changes, their unique management style could affect the fund’s performance. Some of his decisions might yield good returns, some might not, even if his decisions fit well within his mandate.
Track the performance of the fund over a period of six to twelve months after the change of fund manager. If it is significantly underperforming, you need to review the entire portfolio and you may need to realign your investments in that fund.
Some fundamental attributes of a plan are its structure, investment model, etc. An example of a change in fundamental attributes could be if a bank fund changes its mandate to also include a non-bank financial company (NBFC) in its portfolio. If the changes are not in line with your investment objective, you may want to consider an exit option.
Regulatory changes include bodies such as SEBI introducing a 25% cap on large caps, mid caps and small caps each for holding multicap fund portfolios. This had caused quite an uproar and SEBI had to introduce a category called flexicap.
Most fund houses changed their names because they didn’t want to reorganize their portfolios. Some funds like ICICI Pru Multicap Fund, Invesco India Multicap Fund and Nippon India Multicap Fund have realigned their portfolio in line with capping standards.
If such changes occur and you are not comfortable with their impact on the plan because it does not match your goals, then you can exit the plan and rebalance your investment portfolio.
4. Consistently underperforming a program? Switch to a new fund
It is observed that not all diets perform consistently and the past performance of the diet should not be the only criteria used to invest in a diet. But when buying back, it’s critical to note a plan’s consistent underperformance over an extended period of time.
Check returns over different time periods and compare the trailing returns of a poorly performing fund against its peers and benchmark returns to see how inconsistent the fund’s performance has been. At times like this, an investment advisor plays a pivotal role, especially for an investor who is unaware of the nuances of finance.
Do some research and try to figure out the reason for its underperformance. Determine if the whole plan category has fared poorly or if the plan has beaten stocks in its portfolio, or if a fund manager has changed or if a particular sector is affected by regulatory changes and the fund manager has taken undue risks. In short, find out why the program malfunctioned and assess whether this is an isolated case or if the adverse factors will persist. This will help you take a call to find out if you should leave or not.
If an equity program has consistently underperformed its peers for three years or more, you may consider exiting the program and moving your investment to a similar, proven fund. But before investing in a similar fund, research the plan quantitatively and qualitatively.
5. Change in asset allocation? Rebalance the portfolio
A change in your portfolio’s asset allocation sometimes occurs due to market movements. At other times, a change in your personal circumstances, such as a change in age profile, requires a change in your asset allocation. In such cases, you might consider rebalancing your portfolio. Asset rebalancing will help you even out investment returns and may even force you to “sell high” and “buy low.”
For example, if your asset allocation is 65% equity and 35% debt. If stock markets rise and the equity allocation reaches 70%, you may need to consider reducing your equity allocation by redeeming investments. Maintaining your asset allocation is important because it keeps your risk tolerance at the most comfortable level.
6. Split and/or Merger of Asset Management Company (AMC)? Revise and rebalance
Consider the rare case where the AMC in which you have invested is sold to another fund company and the system is merged with a similar system of the latter. Then, evaluate the performance, purpose, and participations of the program to see if they have changed or not.
AMCs are sold for different reasons; however, the purpose of the merged plan is unlikely to differ from the one in which you originally invested. If the performance of the merged plan continues to be satisfactory, stay invested but if it is not satisfactory, replace it with a new similar plan from a different AMC.
7. Is there an emergency? Exiting the plan or suspending your Systematic Investment Plan (SIP)
In an emergency, when your emergency fund is insufficient to deal with the situation, you may consider getting out of a plan. If you are unable to continue paying your SIP installments, you can also suspend monthly SIP for a period of time.
Most AMCs offer an option to suspend SIPs, if you find it difficult to continue due to an unforeseen emergency. Stopping your investment in the program will prevent you from developing a larger corpus and it might become difficult to restart a SIP.
The other option is to withdraw previous SIP amounts and reinvest them to continue your investments, but do not stop your SIP investment. If withdrawal is imminent, be sure to withdraw non-performing funds first, then performing funds; even in well-performing funds, look at long-term payback first, then short-term.
Patience is the most important attribute needed in investments and especially when there are steep declines. However, it is important to control your emotions and not get carried away by the buzz of the markets. Stay on your asset allocation path and avoid market timing.