There are some facts regarding investing that all of us are aware of. Such as the benefits of investing early, investing for the long term, and mutual funds being a good option of investment. But along with these, it is also important to know when to exit a particular mutual funds scheme. While the simple answer may be to exit mutual funds when one’s goals are achieved, it is not the best idea to stay put with a mutual fund scheme for an undue period. There are certain factors that one must keep in mind for exiting mutual funds which will be discussed in this article. Exiting a mutual fund scheme at the right moment will prevent loss as well as not restrict the opportunity to invest in places of even more profit.
Reasons to exit mutual funds
1. Consistent and poor performance
The stock market is a volatile place and hence mutual funds’ returns will also always go through ups and downs. Hence, it is important to see one’s annual returns in the long term, and not look at the performance of just the past couple of days to gauge mutual funds’ performance. In the grand scheme of things, the performance of a few days or weeks does not matter. But one needs to see if their mutual fund is performing poorly consistently over a long time.
How to check mutual funds performance?
1. Compare with its benchmark index
To know the performance of a mutual fund, compare it with its benchmark index. However, do not start comparing all funds to Nifty 50 or Sensex. For example, one wants to check the performance of Axis Small Cap Fund which invests in small companies only. Hence, it is redundant to compare it with Nifty 50 or Sensex, which is not of the same level. Thus, compare Axis Small Cap Fund against Nifty Small Cap 100, which is the benchmark index. If Axis is performing lower than Nifty Small Cap 100, then it is a bad fund and if it is performing more then it’s a good fund.
2. Compare with the category average
Check the return of the funds with its category average. For this, check if the return of Axis is lower or higher than the average return of all small-cap funds. Simultaneously, one must note to not opt for only that fund that performed well in one particular year. Since there is no guarantee that it will again perform the best next year. Rather opt for mutual funds which is performing higher than the category average. Since having a higher than average performing mutual fund increases chances of it being the best performing fund for certain years as well.
2. Portfolio rebalancing
Asset allocation ensures that one’s financial goals are ultimately achieved. To get the best asset allocation, it is necessary to rebalance the investment portfolio at certain times. Thus, exit of mutual funds may happen in such cases.
For example, one has a fund value of Rs 1 crore which they allocate as 60:30:10 for equity:debt:gold. Thus, final investments for equity will be Rs 60 lakh, debt will be Rs 30 lakh and gold will be Rs 10 lakh. Now if the market crashes, then equity funds would lose only Rs 24 lakh as against Rs 40 lakhs if all 1 crore was invested in equity funds. Simultaneously, with market crash, gold prices will rise and profits will increase there.
Now if market rises, and equity:debt:gold funds become 90 lakh:32 lakh:11 lakh, then one needs to do asset reallocation to maintain the 60:30:10 division. This is known as portfolio rebalancing. Now, one has to deduct 10.2 lakh from equity funds by exiting mutual funds and add 7.9 lakh each to debt funds and gold investments to maintain the portfolio balance. Moreover, asset allocation must also be done basis goal achievements and not overall wealth distribution. Asset allocation also helps in buying low and selling high, thus reducing risk of overall investment portfolio.
When to do portfolio rebalancing?
Frequency based – Look at the portfolio division once every 6 months or a year and rebalance the assets.
Trigger based – If the division of assets changes by a certain amount.
Tactical – Using one’s knowledge of the stock market to predict if it is going to crash or rise next.
What is profit booking?
Sometimes one may invest in some mutual funds because certain market conditions or factors are favourable. For example, when market crashes, small cap funds become cheap, hence one invests in them for a short time period. Thus, when favoured goals are achieved through it, one can exit those small cap mutual funds and get a good profit in a short term. Furthermore, they can invest that profit to their regular investments schemes to further increase their wealth. This is known as profit booking and one may exit mutual funds for this reason as well.
3. Approaching your goals
To understand this, say one has the goal to achieve Rs 1 crore in 20 years with 70:30 equity:debt asset allocation. After 16 years, one has already made Rs 80 lakh and now wants to reduce their risk in investment. Hence, they will slowly start removing funds from equity and shifting them to debt or gold gradually as they near the end of their goal term. This is because, when close to achieving the goal one must not take any unnecessary risks. Thus, slowly their equity:debt asset allocation should become 10:90 or 0:100 by the end of the goal term.
Hence, it is important to identify one’s financial goals and the duration required for it first. Then they should figure current asset allocation and rebalancing of asset allocation in the last 5 years of the duration. This will lead to exit of mutual funds eventually and is a valid reason as well.
How to rebalance asset allocation for goals?
Systematic Transfer Plan – To transfer funds from one’s equity funds to the same AMC’s debt fund or liquid fund, one can set up a Systematic Transfer Plan (STP). The AMC will automatically transfer set funds on set dates as per one’s choice so one doesn’t have to do it manually. However, this option is not valid for transferring funds to another AMC’s funds.
Systematic Withdrawal Plan – This can be set up to gradually withdraw equity funds over a period of time. The AMC will withdraw set amount on set dates and transfer to one’s bank account in this case.
4. Fund manager replacement
One may often invest in a mutual fund because they have confidence in the fund manager. In that case, exit of mutual funds is an option. But another option is also to stay and watch the performance of the new fund manager for some time. In which case, one must study the monthly portfolio disclosure documents that they receive. That will show if the division of funds is too skewed towards only one sector by the new fund manager compared to old fund manager, in which case he is taking higher risks. It may ultimately lead to high gains or high loss depending on the performance of that one sector then. If one does not like this, then they can exit the mutual funds.
5. Tax harvesting
The last reason to exit mutual funds is tax harvesting which needs to be used strategically along with the other reasons. If one holds their stocks or equity mutual funds for 12 months before selling, then if the profit received is over Rs 1 lakh, it incurs 10% tax. This rule can be used to one’s advantage.
Say, one invested Rs 5 lakh for 10 years and it became 15 lakh. The 10% LTCG tax on it will be 10 lakhs, out of which 1 lakh is exempt so the final tax will come to Rs 90,000. Instead, one can redeem their long-term holdings every year, for investments under Rs 1 lakh and reinvest the same. So, the Rs 5 lakh will be exited after one year when it hits Rs 6 lakhs, thus showing no LTCG on paper yet keeping full profit without any tax payment. This process is called tax harvesting and exit of mutual funds to reinvest them is necessary for the same. Although, the process may be a little complicated.
Watch more details on exit of mutual funds below.
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