No change should ever be recommended to an existing portfolio without first providing an analysis of the allocation, investments and the risk and return profile of the existing portfolio, as well as its appropriateness to the individual’s financial needs and risk preferences.

If the advisor cannot justify a change on fundamentals then why should they be allowed to incur the costs of change on the individual’s behalf?

This is important, because it should be extremely difficult to be able to justify the sale of all investments. Indeed, this section is just as important for the explanation of the reasons for retaining certain investments.

Mutual funds are an important case in point.  Mutual funds are essentially asset allocation vehicles in that they are either allocating to a market in general, a specific area of a market and/or a particular investment style.  Because of this, an advisor who uses mutual funds to allocate investments should be able to retain a good portion of the existing investments.

In fact, the primary reason for buying a mutual fund should be its asset allocation and its style, not its performance.  Because of this, an advisor needs to have an asset allocation framework.  All that they should use mutual funds (and ETFs) for is to build up the asset allocation.  The asset allocation should only be changed as relative risks and relative valuations change, which means the advisor needs investment discipline and asset management expertise.

The main reasons for selling an existing mutual fund are as follows.

• You already have enough larger company/mid cap/smaller company exposure and the fund is merely selling the over weight position.

• You need significant additional yield from your portfolio and the allocation you have does not provide sufficient yield. 

  • Note that a marginal yield differential is not sufficiently good an argument since the additional yield could take years to cover the transaction costs.

  • Note that too high a yield is not sufficient argument for a sale for an investor with no yield requirement because both value and contrarian styles, with higher yields, could be appropriate investments. 

• You are a conservative investor and your large cap/mid cap/smaller company exposure is invested in higher risk investments and a more conservative allocation is needed and vice versa for an aggressive investor with too many defensive conservative holdings.

• You have too much in one market and funds need to be sold in one and bought in another.

• The fund is basically a mirror of an index fund and you could get the same allocation for a much lower cost through an index investment.

The only instance where a like for like transaction should take place is where there are clear grounds for change based on poor discipline, lack of expertise and resources backing the fund so as to place real concerns over its ability to add value and manage risk.

Why are mutual funds sold inappropriately?

While the arguments needed to sell individual equities are slightly different, the advisor still needs to be able to justify his or her strategy in terms allocation, valuation and risk management.  Importantly an advisor who is selling mutual funds to buy equities has to justify the validity of their investment strategy and recommendations relative to the allocation and the management of the existing mutual fund holdings.  A mutual fund with no trailer fees is unlikely to be more expensive than the average direct equity portfolio.  Additionally, while the performance of a mutual fund is accessible, the performance of the average direct equity portfolio is not. 

There is no point in selling your mutual funds if all you are going to get is the same type of investments, the same level of diversification and more or less the same performance.