Holding vs Folding a Poor-Performing Fund: Points to Discuss with Your Financial Advisor

It is late in the evening. You have just finished dinner after a good day, and you open your mutual fund app to see how your investments are doing. One mutual fund is lagging far behind the others, and you feel unsettled in your stomach and get an urge to act and do something to curtail the loss. What do you do now? Selling a poor-performing mutual fund too early can lock in losses and cause you to miss a recovery, while holding on too long can drag down your long-term wealth.

You call your financial advisor and ask for a meeting as soon as possible. But what should you do at that meeting?

Here are some points to discuss in a mutual fund performance review:

1. First things first, understand how the market functions and the reason behind the poor-performing mutual fund

Before you do anything, find out what is really going on. Start by understanding why the investment is lagging and how the market works. There are several things to understand. Firstly, investment performance is not linear. It's not uncommon for investments to show losses. A mutual fund can gain 15% one year, lose 10% the next. In fact, the investments with the most long-term growth potential are often the bumpiest in the short run.

This is especially true of stocks. Stock funds swing far more than bond funds. Remember early 2020? Stocks dropped sharply within a few weeks, then recovered eventually. But the people who sold their stocks in a panic locked in their losses and missed the rebound. That is why, instead of reacting, you must hold on and understand why a mutual fund is underperforming so you know exactly when to sell.

What could be dragging your fund down? These are a few of the usual suspects:

• There may be a change in management: The fund may have a new manager. When a fund has a new portfolio manager, they may change the strategy. Everyone has a distinct way of working, and these changes may affect the mutual fund's performance in various ways.
• The fund may still be young. New equity funds may hold fewer stocks and be more volatile than others. They have a rough start but can catch up in time with the right approach.
• The fund's underlying investments may be struggling: A mutual fund is a collection of stocks, bonds, and other assets. Its returns depend on how those holdings perform. If these securities underperform, they can pull the whole fund down.
• Economic changes may affect returns: Broader economic factors like inflation and the Federal Reserve's (the Fed) interest rate decisions can weigh on stock and bond prices.
• The fees may impact returns: They are easy to forget and overlook. However, every fund charges an expense ratio, which is deducted from your returns every year. On a $50,000 investment, a fund with a 1% expense ratio costs you about $500 a year. Over time, these fees can add up.

Your financial advisor can explain these reasons in detail so you know which ones apply.

2. Ask them how the performance of one fund impacts your portfolio

If you are wondering what to do with a poorly performing mutual fund, you should look at your portfolio's overall asset allocation strategy. A well-balanced portfolio can likely include a mix of stocks, bonds, cash or cash equivalents, gold, and other assets. You may have equity mutual funds or index funds, but you would also likely have money market funds and Treasury bills. Your overall asset allocation has a greater effect on your long-term returns than any single fund. Let's consider an example:

Let's say you have $200,000 invested in total, and the poor-performing mutual fund is worth $20,000. This accounts for only 10% of your entire portfolio. If the rest of your portfolio is performing well, you would not be at an overall loss.

Each asset class reacts differently to market conditions. Anddiversification ensures that when certain fund holdings fold, others can hold up. As an investor, your goal is to keep your overall risk in check. If market movements shift your allocation over time, periodic rebalancing, guided by a financial advisor, can help bring it back in line. In most cases, one weak fund is not a cause for concern, because your other investments are likely doing their part.

At your meeting, ask your financial advisor these questions:

• What share of your portfolio does this fund represent?
• Does your current allocation match your financial goals and risk tolerance?

The answers will help you view the bigger picture of the poor-performing mutual fund plays in your overall financial plan.

3. Discuss your emotional reaction to the fund's performance

A poor-performing mutual fund can lead to losses, but it can also do more than that. It can stir emotions that drive you to make rash decisions. Investment planning can succeed if you make logical decisions.

When an investment drops in value, you may be tempted to sell it. However, the money you have already lost should not drive your next move. Selling it will only lock in those losses. Until you take action, the loss or profit is only on paper. But the moment you sell, you make those profits and losses real. You may want to sell the investment to get back part of your money and avoid further losses. But you may miss out on recovery. You should also focus on the other side of the fence. Often, investors keep a declining fund simply to get their money back, even when there is little sign of a recovery. But the money you have already lost should not drive your next move. Ideally, in such a scenario, you should think: if you had this cash today, would you choose this fund?

Emotional decisions can also stem from peer pressure. A friend or a coworker may suggest what to buy or sell in a market downturn. Your colleague may recommend folding the poor-performing mutual fund and purchasing a new one. But before you act, ask yourself how well-informed that person really is. Even a sound idea may not suit your goals, timeline, or risk tolerance.

Talking with a financial advisor about your emotional reactions or urge to buy or sell can help you gain perspective. It can help you evaluate your instincts and make rational decisions that align with your needs.

4. Ask the financial advisor if the underperformance is temporary or if these investments have no chance

As covered earlier, a poor-performing mutual fund can fall behind for many reasons. What matters now is whether those reasons are temporary or likely to stay. Your financial advisor can help you tell the difference.

Every fund has weak patches where it may underperform. For instance, if your fund is lagging because its entire sector is struggling, it may recover once conditions improve. Oil and Gas was among the worst performers in 2020, when oil demand collapsed. But the sector bounced back later, and investors who sold during the downturn missed that rebound.

But sometimes the problem may be lasting. The fund may have a weak manager, or its strategy may simply not be working. In these cases, waiting may not help. The clearest warning sign is consistency. A fund that trails its benchmark for one year may be having a rough patch. A fund that is underperforming consistently year after year may have a deeper problem.

To judge performance fairly, you can compare the fund with a relevant benchmark, such as the Standard & Poor's 500 (S&P 500). This can change how you see the numbers. Suppose your fund lost 6% last year, but the S&P 500 lost 7% over the same period; your fund actually held up better than the market.

At your meeting, ask your financial advisor to show how the fund has performed against its benchmark over several time periods. This can help you decide whether the fund deserves more time or whether you should move your money to another alternative.

5. Inquire what moving your money will cost you

If and when you sell a mutual fund, you have to incur some exit costs. Add up all these costs before you switch.

Some funds charge a redemption fee. Some may charge an exit load. You may also owe capital gains tax. Gains on funds held for one year or less are taxed at your ordinary income rate, while gains on funds held longer qualify for lower long-term rates of:

• 0%
• 15%
• 20%

You would also incur trading commissions or purchase fees on the new fund. If you are switching funds inside a 401(k) or Individual Retirement Account (IRA), there should not be any tax implications. But outside of these, you will likely owe some capital gains tax.

These costs are worth considering, but they shouldn't deter you. Keep in mind that these costs are paid once, while a weak or expensive fund can hold back your returns year after year. So, take a comprehensive look at the entire situation and decide for yourself.  Ask your financial advisor to run these numbers so you can weigh the long-term impact of holding on against the cost of folding.

6. Evaluate the alternatives before selling

Suppose you have reviewed the facts and decided to sell. You also need to know where the money will go next and what your options are.  

You can shift to a different sector, for instance, from technology to tourism. You can change the size of the companies you own, such as moving from a large-cap fund to a small-cap fund. You can also move to a different asset class altogether, such as bonds or cash equivalents.

To make this choice, consider what has changed in your life. The fund's performance should not be the only factor in your decision. Your personal circumstances, such as getting married or divorced or having a child, can affect your decision. Your time horizon can also dictate your investment mix. For example, the closer you get to retirement, the less time you have to recover from a downturn. So, you may want to move proceeds into a bond fund.

Whatever led you to sell, review these factors with your financial advisor before you reinvest. Ask which alternatives match your current goals, timeline, and risk tolerance.

What to do with a poorly performing mutual fund – hold or fold?

You should be able to answer this question after a detailed mutual fund performance review with your advisor. Your financial advisor can explain how broad market conditions are affecting the fund and point out other factors that may be holding it back, such as a change in management, high fees, etc. They can also show you how the fund fits into your overall portfolio and what a switch would really cost.

If you don't have an advisor yet, our advisor directory can connect you with financial advisors in your area who can review your investments and help you decide whether to hold or fold.

Frequently Asked Questions (FAQs) about poor-performing mutual funds

1. What to do with a poorly performing mutual fund?

Start by reviewing the fund's performance and finding out why it is lagging. Compare it with a relevant benchmark over the long term. If the causes look convincing, it may be time to move your money to a fund that better suits your goals. But if the downturn is temporary, holding on and giving it time to recover may be the wiser choice.

2. Should I sell a losing mutual fund?

Not necessarily. A short-term loss alone is not a strong reason to sell, and selling too soon can lock in that loss. Before you decide, conduct a mutual fund performance review with your financial advisor. Look at why the fund is down, what role it plays in your portfolio, and what selling would cost you in fees and taxes. Then decide based on your long-term plan.