MARK RIEPE: Welcome to Part 2 of our special episode on “When Should You Sell?”

In Part 1, we looked at the decision of when to sell individual bonds and individual stocks. Today we are going to analyze the sell decision for funds. By that I mean mutual funds and exchange-traded funds, or ETFs.

While mutual funds and ETFs share many traits, there are some key differences between them. And those differences can have an impact on when you decide to sell.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.

Before I get into the details of selling funds, let’s take a step back.

In Part 1, we discussed how assessing the securities in your portfolio can be like cleaning out your book collection. If you have investments that are no longer serving their purpose, it might make sense to sell them.

I’m focused on selling because successful investing is not only about what you buy and when you buy it, but also what you sell and when you sell it.

We’ve covered some of the cognitive and emotional biases associated with selling way back in Season 1. In fact, our very first episode covered selling.

In that episode we talked about the psychology of the sell decision and how choosing to keep or to sell a stock or other investment can be complicated because of something called the disposition effect.

This is something that many investors are prone to, which is the tendency to sell assets that have increased in value but hold on to investments that have dropped in value.[1]

The disposition effect is driven by loss aversion.

If you’re like most people, a $1,000 loss hurts about twice as much as the positive feeling experienced from a $1,000 gain.

This means you’re reluctant to turn an unrealized loss on an investment, also known as a paper loss, into a realized loss by selling it.

Selling magnifies the pain because realizing a loss is tantamount to admitting that you made a mistake.

As long as the loss is only on paper you can take comfort from hoping that the stock will bounce back. That hope vanishes once the loss is realized.

What’s interesting about mutual funds is that it doesn’t appear that the disposition effect holds.

In fact, the reverse seems to be the case. Holders of mutual funds tend to be much more willing to sell when a fund performs poorly and put money into a fund that’s had good recent performance.[2]

It seems that mutual fund holders pay close attention to recent trends and over-extrapolate those trends far into the future, and so they think underperforming funds will continue to underperform and winning funds will continue to win.[3]

The psychology here is interesting because when you own a fund, you as a shareholder are, in effect, hiring a management company to make decisions about how to invest the money.

Being one step removed from the decision seems to change the decision-making dynamics.

Many mutual fund investors act as if they’re a coach on a sports team who puts a player in the game.

If the player does well, they leave the player in, but if the player screws up, they immediately yank the player from the game.

Good coaches, of course, recognize that they need to give players a chance, and because there are so many variables that determine success, it takes time for the true skill of a player to make itself apparent.

With that let’s turn to our interviews.

First, I’ll speak with Michael Iachini about when to sell a mutual fund. Michael is a vice president at Charles Schwab Investment Advisory and head of manager research. He’s a Chartered Financial Analyst® and Certified Financial Planner™. If you see a fund on Schwab’s Select List or been recommended a fund by a Schwab representative, then Michael’s team probably reviewed it.

Then I’ll speak with Emily Doak. She’s a managing director of exchange-traded fund research also at Charles Schwab Investment Advisory. Emily’s been with Schwab for many years and I have yet to stump her with a question about ETFs.

 I’m joined now by Michael Iachini. Michael is a vice president at Schwab and head of manager research. Michael, thanks for joining me today.

MICHAEL IACHINI: Great to be here.

MARK: We’re talking about when to sell various securities today. So what should someone consider selling when it comes to a mutual fund?

MICHAEL: Well, you should start by considering taxes. So if you own a mutual fund in a taxable account, and let’s say it’s gone up a lot in value since you bought it, that’s great news, you’ve made money. But that means that if you sell it, you’re going to realize a capital gain, and you’ll probably owe taxes on that capital gain right now. So that might be a reason to think about not selling it right away, because you would have to pay those taxes. On the other hand, if you have a fund that’s gone down in value since you bought it, it’s bad news that you’ve lost money, but it means that if you sell it, you’ll realize a capital loss. That’s a form of tax-loss harvesting, which can help save you money on taxes. So that might be a reason to accelerate your selling decision on that fund where you’ve lost some money.

Another thing to think about with a mutual fund is consider whether there’s a lower-cost option out there compared to the fund you currently own. This might be a different mutual fund or maybe an exchange-traded fund. And this is really something to think about, in particular, if you have a fund that you bought a long time ago. Fund costs in the industry, in general, are much lower today than they were, say, 10 or 20 years ago. So if you owned a fund for a long time, you might find out that that fund’s competitors have gotten less expensive today.

MARK: Michael, when it comes to expenses, expenses are really important. Is a … if there exists a lower-cost option, is that an automatic sell, or is that just something to consider that perhaps would cause you to sell, but not necessarily to act on it immediately?

MICHAEL: Yeah, having a lower-cost option out there is not an automatic sell decision. Partly, it is about that tax question that I talked about. You know, if you have a big unrealized gain in a fund, and that fund is a little more expensive than peers, it still might cost you money in taxes if you sell the fund today rather than hanging on to it. But, also, costs are not everything. We try to make sure investors understand the importance of keeping your financial costs low for those investments. But if you have a fund whose performance has been excellent and whose performance you think will continue to be excellent in the future, despite a somewhat higher expense ratio, that’s not a fund you should dump. I mean, that’s a fund that is likely to deliver you good performance in the future. So consider costs, yes, but a higher-cost fund is not an automatic sell.

MARK: Michael, every mutual fund on its prospectus, it says that past performance is no guarantee of future results, and yet we know that in many cases, people do sell funds because they believe the fund is underperforming. So how do you think about performance when it comes to the sell decision?

MICHAEL: Yeah, performance is a really important factor when you consider whether you’re going to sell a fund or not. But, really, you have to keep in mind that it’s about future performance potential. So we don’t know what future performance will be, of course. But one mistake that we often see investors make is they own a fund whose investment style has been out of favor, and they’re disappointed with it and decide they want to sell. So, for instance, value stocks have been kind of out of favor in the market for quite a long time now. Growth stocks have really been leading the way with a lot of big technology companies, in particular, doing well. So if you own a fund that’s really a value fund, and it’s a good value fund, but it hasn’t kept up with growth stocks, you might decide, “Ah, never mind, value investing is no good. This fund manager is no good. I’m going to sell it.” And you decide to sell it right before markets change, and now value stocks are leading the way again. We never know when that might happen, of course, but just because an investment style has been out of favor, it doesn’t mean the manager has done a lousy job as an investment manager for you, so that’s not really the right time to consider selling a fund. You should really be thinking about what’s going to happen in the future. And while you can’t know for sure, if the fund manager still seems to be skilled, under-performance in recent years isn’t really a great reason to sell.

One other wrinkle to think about when it comes to whether you might sell a fund or not is some funds will close to new investors. And so this usually happens if the fund has gotten too big and too much money has flowed in too quickly. They’ll say, “We don’t really want too much money now, so we’re not going to let new investors in.” If you already own shares, you might still be able to continue adding to it. So if you decide you want to reduce the amount of this fund that’s in your portfolio, you might consider hanging onto a small piece of it if it’s closed to new investors, or you’re worried that it might close in the future. As long as you have some money in the fund, you can probably add more to it later. But if you sell it entirely, it’s possible you might not be able to get back in.

MARK: Michael, when you invest in a mutual fund, in effect, you’re hiring a manager to make buy and sell decisions on your behalf. That’s the fund manager. So what about a change in fund management—that does happen from time to time—is that a reason to sell, especially if performance has been good, or is that actually a reason to hang on if performance has been poor?

MICHAEL: Well, if the manager on your fund changes, you should think about how much does that individual matter to your reasons for owning the fund? So, for instance, there are a lot of mutual funds these days that are managed by a team of people. You might have three or four or even more individuals who are all portfolio managers. And maybe there is a very firm investment approach that those managers are all implementing together. So if one of those people leaves and is replaced by an analyst from the fund, most likely not too much is going to change with the fund in the future. So if you’re satisfied with the fund, no reason to sell it just because one member of a team has departed. On the other hand, if you’ve hired a fund manager because they’re a star—you really think this person is a genius, and you bought into the fund because you wanted access to their investment ideas—and that person leaves, well, then that probably is a reason you’ll want to consider selling the fund since the whole reason you bought it in the first place is gone.

Now, when it comes to performance, it is certainly the case that sometimes a fund company will see that a fund has been performing poorly and decide to replace the manager, really effectively firing them and hiring somebody else instead. And if you own a fund where that happens, it is quite possibly the case that the new manager will do better than the old one. But really think about what’s going on here. You hired this manager—you hired this fund into your portfolio for a reason—and the one thing you can be pretty certain of in this situation is the fund is going to change. It’s going to be very different in the future intentionally because the past hasn’t gone well. But if the reason you bought the fund was to fill a certain role in your portfolio, and now the fund is going to be very different, most likely that’s a chance for you to consider maybe harvesting some losses, selling that fund, and moving on, because it’s going to be so different going forward from the reason you bought it in the first place.

MARK: Michael, some people own mutual funds in taxable accounts. Some people hold them in tax-deferred or tax-free accounts. Do you approach the sell decision differently depending on the tax status of the account?

MICHAEL: The tax status of the account matters a lot, yes. If you’re looking at a tax-deferred account, like an IRA, really, taxes should not come into play at all when you’re considering whether to sell a fund now or wait until later, because those capital gains and capital losses that I talked about before, they just don’t apply when you’re in a tax-deferred account. If it’s a taxable account, that’s where your regular brokerage account is going to have capital gains or capital losses that you will owe taxes or be able to save taxes if you sell a fund at a loss. So in that taxable account, yes. Think about the tax impact—harvest those losses if possible, where it makes sense to do so. But in any tax-deferred account, taxes really shouldn’t enter into your buy or sell decision for that mutual fund.

MARK: Michael, I want to go back to the performance question again. When you’re evaluating the performance of a fund you own, is it best to look at the absolute performance of the fund or the performance of the fund relative to its peers or other funds that are following more or less the same approach, the same strategy?

MICHAEL: Relative performance is really what matters most when you’re evaluating a fund’s performance, not just is it up or down. So, for example, if you have a situation where the market that this fund invests in—say, it’s the U.S. stock market—is down 10%, and the fund is down 5%, well, you might be unhappy from an absolute perspective because you’ve lost money. But this fund manager protected you. They only went down half as much as the market overall did. That’s a great job by a fund manager protecting you on the downside. So on a relative basis, they did very well. That’s a fund manager you’re probably very happy with. On the other hand, if you’re in a situation where the market that this fund invests in is up 20 or 25%, and the fund is only up 10 or 15%, even though you’ve made money, that manager has really let you down. You would have been better off going with another fund out there in the same market or maybe an index fund that just gives you market-like performance. So that relative performance is really what you should be focusing on.

Of course, it’s really important to make sure you’re comparing the fund to the right benchmark, or the right peer group. So if you’re talking about the market going up or down, you might be talking about the U.S. stock market, maybe represented by something like the S&P 500® index, which is very widely followed. And that’s a good benchmark for large U.S. companies. So if you have a mutual fund that’s buying U.S. companies, sure, that’s a good benchmark. But if you’re talking about a fund that’s investing in bonds, then the S&P 500 is not a relevant benchmark. Or, let’s say, it’s a fund that’s investing in international companies or very small companies. You have to make sure you compare it to peers, other funds that are doing the same thing or a benchmark index in that same part of the market. That relative performance matters, but it’s got to be relative to the right benchmark.

MARK: Michael, last question, then I’ll let you go. Let’s say you own a fund and you notice that other shareholders in the fund are starting to sell and leave the fund, and you see the assets under management in the fund dropping—is that a reason to sell?

MICHAEL: If you see a fund getting smaller, it is not necessarily a reason to sell. So on the one hand, you can have a situation where a fund being smaller could be good for you. So, specifically, in our research, we found that funds that focus on illiquid securities, say, very small companies whose stocks might be hard to trade, having a smaller size of assets in the fund is a better signal for those managers because it’s not as hard for them to reposition their portfolio if they’re not moving around as large a slug of assets. So that fund getting smaller could actually be good for its future performance potential. But that said, if you see a fund’s assets dropping quickly, it’s a reason for you to take a look at the fund and see if you can figure out why. What is going on? Because what you don’t want to have happen is find out that you’ve missed something. So we talked before about, you know, underperformance and manager changes and things that might be a reason that you could consider selling a fund. Well, if that’s been happening with the fund and you haven’t noticed, and the first alert you get to it is, “Whoa, the fund’s lost a lot of money,” that’s a reason for you to check into it and see maybe some other investors have noticed something that you haven’t. But if you look at everything and it looks good, you know, you still think the fund has good performance potential, you like the management team, it still makes sense for your portfolio. Then just because other investors have sold the fund is not a reason for you to sell it.

MARK: Appreciate that, Michael. Thanks for your time today.

MICHAEL: Great. Thanks for having me on the show, Mark.

MARK: Joining me now is Emily Doak. Emily is a managing director of exchange-traded fund research at Schwab. Emily, thanks for being here today. Let me start by asking, are there any situations where investors should definitely consider selling an ETF?

EMILY DOAK: Hi, Mark. One reason to sell is when the ETF is changing its index, and the new index no longer meets your needs. Fortunately, most index changes are fairly minor. For example, capping the maximum weight of any security or any sector in an index is pretty common. And these types of index changes probably aren’t a reason to sell.

MARK: Almost all ETFs are built to track an index. If that changes, it could be that the ETF will behave quite differently in the future. And that may not make sense for your situation. Emily, do you have any examples of that, where, you know, the ETF went through a really big change?

EMILY: Well, the biggest change we’ve seen is when an ETF tracking an index of Latin American real estate securities switched to one focused on the cultivation of cannabis about three years ago. Clearly, switching from Latin American real estate to marijuana production is a major change and likely a good reason to sell for those investors who wanted Latin American real estate.

MARK: That is a great—albeit an extreme—example. As you mentioned, though, most situations probably aren’t so clear cut. What are other factors should investors consider if they’re thinking about whether or not to sell an ETF?

EMILY: Assuming that an ETF still meets your needs in terms of its investment strategy—in other words, the ETF’s holdings and its index are still a good fit with your portfolio—here’s what you should consider when deciding whether or not to sell. First, is there a significantly lower-cost option? The continual reduction in ETF fees is sometimes called the race to zero, but that can be a little misleading because not all ETFs are dropping their fees. Some particularly older ETFs have been significantly undercut on costs by ETFs launched more recently. Although you’ll have to consider your tax situation and how much it will cost to trade, it might make sense to switch ETFs when there is a significantly lower cost option. Second, if the ETF is in a taxable account and it has a loss, you might want to consider tax-loss harvesting. More information about that strategy can be found on Schwab.com.

MARK: Emily, are there any conditions where an ETF may not be ideal, but by itself that situation or condition isn’t enough to automatically trigger a sale?

EMILY: Uh-huh. There are a few situations where you might consider selling an ETF, but if these are the only reasons, we think you might want to hold off. First, the bid-ask spread or the premium discount has increased. Since these are trading metrics, unless you’re an active trader, you don’t really need to worry about temporary spikes in bid-ask spreads or bigger premiums and discounts, especially when they’re due to overall market volatility.

MARK: Before we move on, could you take a step back and explain what the bid-ask spread is and why it sometimes matters and why it sometimes doesn’t?

EMILY: Sure. One of the great things about ETFs is that they trade throughout the day on national exchanges. This means that even if there are no other individual investors who are ready to buy when you want to sell, there are professional market-makers who are standing by ready to take the other side of the trade. However, the way these firms are compensated is through the bid-ask spread, which means that at any point in time, the highest price they would pay to buy an ETF is less than the lowest price they would accept to sell an ETF. The difference between those two prices is the spread. When there are lots of market-makers competing to be the ones to buy or sell from investors, which is the case for lots of big and popular ETFs, the bid-ask spreads tend to be small, like a penny or only a few hundredths of 1% of the ETF’s price. For ETFs that are less popular or for ETFs that hold less frequently traded securities, the spreads can be much wider, even up to 2 or 3%. Spreads are also influenced by the overall volatility in the market. When markets are more volatile, spreads tend to increase, and when markets are calmer, they come back down. Finally, always try to trade when U.S. markets are open. Trading after hours will usually result in less favorable prices for your trade.

MARK: What about the premium discount? You also mentioned that earlier. What does that measure?

EMILY: The premium discount is the difference between the market price of an ETF and the aggregate value of its underlying holdings. One of the problems with premium discount is that it’s very hard to accurately calculate the value of the underlying securities in lots of asset classes. For example, there are lots of corporate bonds that don’t trade very often. So figuring out what they’re worth requires estimating their value versus similar bonds that have traded. Also, international securities don’t trade when the stock exchanges in their home countries are closed. So, generally, when we think about liquidity for individual investors, we prefer metrics that are more cleanly calculated, things like assets in the ETF, its average bid-ask spread, and its daily traded dollar volume. However, we’re really just getting back to what I mentioned earlier. Investors will get better prices when there are lots of market-makers competing for their trades, and that’s more likely to happen in larger ETFs and in ETFs where the underlying holdings are also more frequently traded.

MARK: OK. What about some other situations where it may not make sense to automatically sell?

EMILY: I know I mentioned fees earlier, and when an ETF has a significantly higher expense ratio than its peers, it might make sense to sell. But we don’t think it makes sense when the cost differences are relatively minor. Of course, you’ll need to evaluate the potential savings versus the cost to switch, but for most investors, small savings in expense ratio aren’t enough to offset the transaction costs and potential tax impact caused by a trade. Also, we’ve noticed that when an ETF is among the lowest cost in its segment, it’s issuer may match or even beat the expense ratio reduction of a competitor within a few weeks.

MARK: Thanks, Emily. Final question. We had your colleague, Michael Iachini, on earlier talking about mutual funds. Are there any differences in the decision between when to sell an ETF versus when to sell a mutual fund?

EMILY: Well, I know Michael mentioned keeping some assets in mutual funds that are closed to new investors just to have a toehold in the fund in case you change your mind and want back in. Fortunately, this isn’t an issue for ETFs because there aren’t multiple share classes of ETFs, and they don’t close to new investors. However, because ETFs trade on exchanges like stocks, the process of selling is different. Investors will need to consider when to sell, ideally when U.S. markets are open, and what type of order they want to place. A market order will be executed immediately at the best prevailing price, which means there’s no waiting around, but there’s no guarantee you’ll be happy with the price either. With a limit order, investors can specify the price at which they are willing to sell. The risk with this is that the ETF may not hit that price and may not trade at all, but the advantage is that investors do know in advance what the price will be. A compromise approach is called a marketable limit order. These are limit orders set at, or very close to, the prevailing price in the market. So you can be pretty sure the order will be executed and you’ll know the price in advance.

MARK: A lot of good information there, Emily. Thanks for stopping by.

EMILY: Thanks, Mark.

MARK: For some investors, the decision to sell a mutual fund or ETF might be very straightforward. Others might struggle trying to decide exactly which fund should be sold first and at what time.

Here are a couple of things you should keep in mind as you decide.

Consider selling when either you or the security you own has changed in a fundamental way. A fund is like anything else you buy: It’s supposed to serve a function for you. If it isn’t doing the job that you need done, then you sell it.

On the other hand, sometimes you change, and your goals as an investor change. Many pieces of your portfolio might be perfectly good things to own, but they don’t make sense for you anymore because of where you are in your life.

It’s a bit like purging your book collection. You might have loved a book in high school, but now that you’re older and wiser, you’re not so attached anymore and can get rid of it without regrets.

Still, it can be a hard thing to do, just as selling out of your portfolio can be difficult.

But hopefully Michael and Emily gave you a better sense of factors to consider and provided tips around what to think about and what not to think about when selling.

If you haven’t listened to Part One, which covers when to sell stocks and bonds, you can go back and listen to it at schwab.com/FinancialDecoder.

Thanks for listening.

To hear more from me, follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.

You can learn more about when selling might make sense for you by visiting the Insights tab on schwab.com.

If you are a Schwab client, you can access a range of tools that will help you evaluate when to sell by clicking on the Research tab after you log in to your account.

For important disclosures, see the show notes and schwab.com/FinancialDecoder.