These red flags may make your fund a 'sell'

Many things could change over the life of both a fund and the investor, which may mean it's no longer the right investment for you. Analyst Dzmitry Lipski names the five warning signs to watch for.

While investors spend a lot of time deciding what fund to buy, they often give little consideration as to when to sell. With markets at these streched levels and volatility on the rise, exiting a fund at the right time is just as important a decision as entering a fund.

Investors who sell at the wrong time are just as likely to experience weak returns as those who buy at the wrong time. Once a fund is purchased, investors should monitor it at least quarterly to ensure that it is following its strategy and delivering returns in line with expectations.

• Your 2-minute guide on when to sell a share

As there are no strict rules as to when to sell a fund, there are common 'red flags' that should prompt investors to review a fund to see if it is still right for their portfolio.

Investors must be able to put emotions to one side when it comes to dealing with red flags and remember to maintain a longer term perspective in order to achieve their investment goals.

Manager change 

A manager exiting a fund can be a red flag, especially when he is the key decision-maker and there is no succesion planning in place. Further investigation is needed.

The new manager should be evaluated as to whether he will continue with the existing strategy based on the same criteria used when you initially purchased the fund.

To mitigate 'key person risk', investors could consider focusing on funds that follow a collaborative team approach rather than depend on one individual.

Strategy change or style drift

Investors should also be mindful if a manager has decided to change the objectives or benchmark of the fund and what impact it could have on your investment objectives.

Often, to chase better returns or to avoid losses, managers can gradually diverge from a set mandate, or experience so-called 'style drift'. For example, a large cap fund has been overeliant on returns from small cap holdings, or a UK equity fund has overexpanded its overseas exposure.

The manager could also have decided 'to keep it safe' by tracking an index while charging higher fees typical of an active manager. Therefore, by monitoring a fund's holdings regularly, investors should be able to spot a manager who’s drifting from his strategy.

Consistent underperformance or extreme outperformance 

Actively managed funds are often more concentrated in specific stocks or sectors than their benchmarks, meaning that some short term underperformance should be expected.

The risk here is that some investors panic and sell during those short downturns and therefore miss out on a potential recovery and longer term returns.

Instead, consistent longer term fund underperformance should be a concern for investors and trigger a review of the fund. Ideally, investors should assess fund performance relative to its benchmark and peers over a market cycle. However, a focus on three-to-five year returns could be sufficient to indetify an issue.

A typical red flag is when a fund lagged its peers at a time when the market environment was favorable for that strategy. For example, if a large-cap growth fund underperforms when large-cap growth companies are in favor. However, if underperformance occurred when small-cap value stocks led the market, this could be less of a concern for investors.

The same is true when a fund produces abnormal returns, significantly better than its peers and worth investigating. For example, a fund could be taking larger higher risk positions, short selling or increasing leverage to boost returns that are at odds with its strategy.

Asset size 

Quite often, the best performing funds experience large inflows and become too big. Managers with large assets usually find it difficult to find opportunities in the market and deliver outpeformance relative to peers.

That is especially relevant for funds that focus on smaller companies or AIM stocks that are less liquid than large cap peers. Some managers are 'soft-closing' their funds at a certain level by imposing an initial charge for new money to protect existing investors.

Economic and market changes

Investors may observe that some views and decisions taken by a manager do not seem consistent with current macro and market environment that could lead to underperformance.

For example, a manager is long duration at a time when interest rate are rising, or is overweight US equitiesthat are in the second longest bull market.