Consider these factors before you redeem your mutual funds

Are you considering redeeming your mutual funds? Here's what you need to keep in mind.

Consider these factors before you redeem your mutual funds

When is the right time to redeem your mutual funds?

Redemption is nothing but a process of withdrawing units from a mutual fund scheme and getting the money back from your investment at the net asset value prevailing on that day. But the question is: when is the best time to redeem a mutual fund? Read on to find out.

Avoid knee-jerk reactions

Investors frequently decide to redeem their units when the market is uncertain or when the fund is under performing. But in most cases, it’s a reflex action, and that may not be ideal. Timing the market is one of the biggest mistakes that investors often make. Investing is all about long-term planning and being patient. It is certainly not about letting market fluctuations blind you.

There are two main reasons why redemption may not be the wisest response. First, one must understand that even uncertain markets can present opportunities for earning good returns. Isn’t this why people invest in mutual funds in the first place – for its returns, keeping in view their future goals or money requirements? If one were to exit prematurely, it can lead to shortfalls in financial goals.

The second reason is that mutual funds (other than index funds) do not always follow the benchmark index; their performance is a function of the specific underlying securities. This is not to say that redemption is a no-no in adverse conditions; if a mutual fund scheme consistently under-performs over a long period vis-a-vis its benchmark, one may choose to exit.

Related: Dummies guide to Mutual Funds 

Some broad guidelines

There is no hard-and-fast rule that identifies the best time to redeem mutual funds. However, there are some broad reasons or situations when exiting or redeeming mutual fund investments that make sense; some of them are listed below:

▸ As stated earlier, redemption may be considered if the fund is consistently under performing; this shall be discussed in greater detail later;

▸ If there is any change in objectives of the scheme which no longer serves your goal or portfolio – this too will be discussed later;

▸ If the fund manager changes and the new style does not suit you;

▸ Financial experts advise re-balancing of one’s portfolio from time to time to stay tuned to changes in market conditions. However, portfolio re-balancing may also be due to changes in the investor’s income and age, which may require one to exit from some funds; 

▸ Often, you may discover there are too many similar types of funds in your portfolio, so selling some of them could give your portfolio a broader and more diversified look;

▸ People usually invest in mutual fund schemes with some specific goals in mind. You may consider selling if the scheme performance is helping you to reach your goal – this too will be discussed in the next section;

▸ You have an urgent need for money but have no alternative way of getting it.

Key redemption scenarios

Let us consider a few red flag scenarios that justify redemption of a mutual fund:

1. Changing asset allocation

A mutual fund invests in various asset classes such as equity funds, balanced funds etc. as mentioned in the offer document, which also mentions the asset allocation limits.

While most equity funds are close to fully invested in equities, there are a few that may have a split allocation between predominantly equity (at least 65%) and the rest in debt or allocation between domestic and international equity.

Thus, an equity fund may invest 80%–100% in equity and 0%–20% in money market securities, while the spread for a balanced fund may look like 65%–80% in equity, 15%–35% in debt securities, and 0%–20% in money market securities.

The fund manager can change allocations within the limits specified, but not beyond them.

Over the years, asset allocations change due to differential returns from various asset classes, and market movements can impact asset allocation significantly. If that happens, it may not suit your goals.

Let’s assume you have set yourself a limit of equity exposure, but the allocation to equity has exceeded your desired level; it is then that you may consider redemption.

What is considered as the ideal allocation to equities varies with each investor, based on their risk appetite. It is generally advised to get one’s portfolio re-balanced after a market shakeup, but if that doesn’t happen, definitely once a year.

As financial advisors often say, the key to wealth creation is being disciplined about asset allocation.

Related: Savvy millennials betting big on Mutual Funds 

2. Imminent goals

Mutual funds have four main advantages: they are professionally managed, have inbuilt diversification mechanisms, and are easy to buy and sell. It is the last factor that makes them ideal for investors to meet their future goals or money requirements.

Mutual funds are easily available through banks and other financial organizations, fund units, or shares. What’s more, they can be sold at almost any time the investor needs access to their money. Ideally, the amount one gets back will be more than what was invested.

So, the second reason for redeeming funds is when the financial goal you are saving for is just around the corner, and you need money.

Ideally, as the goal deadline approaches (2–3 years away), you should start moving your money out from equity mutual funds, which are ideal for long-term objectives, to debt funds, which are liquid and good for short-term goals as you can withdraw your money on any business day. This way, you also safeguard your profits from market volatility. 

The best way to go about this is via a Systematic Transfer Plan (STP), which enables investors to give consent to a mutual fund to periodically transfer redeem certain units from one scheme and invest in another scheme of the same mutual fund house

You should start doing this process of shifting at least two years before you need the money, or earlier if the retirement corpus is the goal and is just around the corner.

3. Postponed goals

With mutual funds, chances of higher returns go up exponentially with the duration you stay invested; in other words, the longer you stay with it, more are the chances of higher returns. You can also enjoy the power of compounding and start investing to create your retirement corpus over the long-term. This is what makes the instrument such a good wealth creation strategy.

Someone may start investing in a mutual fund specifically to buy a car two or three years down the line; this would be a short-term goal. However, the goal might change nine months later, and that person may start thinking in terms of buying a house instead.

This is a long-term goal 7–8 years away or even more, when a ‘buy-and-hold’ mindset is called for. But what is also required is a change in asset allocation – a switch from equity fund to a debt fund for the reasons explained earlier.

Therefore, a change of goals may also necessitate the redemption of mutual funds.

4. Consistent under-performance

Mutual funds are market-linked instruments and you should not press the panic button just because of falling returns, especially over the short term. When the broader market is down, no fund can escape a decline. 

But if you are still worried about your fund’s performance, check how other funds in the category have performed, or are performing. Only then can you ascertain if the fund has ‘under-performed’ or not. 

If it is performing below the peer group for less than a year, redeeming may not be the best idea because the market may simply be experiencing short-term fluctuations. However, if the performance has been significantly poor over the past two years or more, it should be a signal to cut your losses and move on. 

Related: How interest rates impact mutual funds

5. Changes in strategy

If the fund you have invested is in sync with your financial goals, you have probably researched it well before investing in it. But one day, as a shareholder, you may be notified of proposed changes to the original prospectus, and soon you find the fund manager investing in financial instruments that do not reflect the mutual fund's original goals.

If this happens, you may want to re-evaluate the fund you are holding because the fund’s new direction may not only be contrary to your goals, it may not match your risk appetite either. For example, if you have invested in a small-cap fund and it now starts investing in large-cap stocks, the risk and direction of the fund may change, making it unsuitable for your purpose. 

Sometimes, a fund may change its name to attract more customers. The thing is, a mutual fund’s strategies also change with its change of name. Fund managers could also change, bringing in a new style of investing; this too may or may not match your risk profile.

If all these changes bother you, you could start thinking of redeeming your shares. At the end of the day, you should be comfortable with the direction of your fund.

Last words

Incidentally, your transactions are liable to attract a certain amount of taxes and exit loads based on the time period after which you are redeeming the funds; you should inquire about it before you close the deal. Also, given that this is an investment decision, it is advisable to consult a financial advisor about the move.

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.