We often caution investors against 'switching' at the wrong moments. But what exactly is switching and how do you know whether or not it is an opportune time to switch? Thandi Ngwane explains.
Switching involves selling units in one unit trust to buy units in another. You can usually make a switch quite easily – at Allan Gray you can do this online or by filling in a form, and with no fees – but as with all investment decisions, you should carefully consider your actions.
Why do investors switch?
Investors are often tempted to switch between funds in an attempt to improve their returns. The fund they originally selected may be going through a period of relatively poor performance and they may sense a better opportunity elsewhere. Selling a unit trust that has performed poorly over a short period is often an emotional response, and emotional switching invariably destroys returns. When your investment has lost value can be the worst time to switch, as you land up locking in losses.
While some investors improve their returns by switching out of one fund and into another, research shows that more often than not switching destroys value. On average, investors earn lower returns than the funds in which they are invested. The point of a unit trust investment is to access the expertise of a skilled manager; your role as the investor is to select a unit trust with investment objectives aligned with your own and to stay invested for long enough to benefit from this expertise.
Some investors deliberately switch between good funds in an attempt to time the ups and downs of each fund's performance. Timing the market is extremely difficult to do successfully, because a large component of short-term returns is random and therefore inherently unpredictable. Regardless of motivation, active switching distracts investors from the important and difficult task of picking a good fund for long-term returns.
Counting the costs
Another reason to avoid switching between funds is that selling units may trigger capital gains tax (CGT). In addition, the fund you switch into may charge initial fees. These short-term costs may seem acceptable for an investor wanting to get into a new fund, but with frequent switches, CGT and other switching costs add up to a significant drag on long-term returns.
So when should you consider switching?
If you have an investment objective and have selected an appropriate unit trust you should usually only consider switching in response to a change in your objective. However, if you are concerned about your unit trust's performance, you need to do some research to check that you have not picked a poor quality fund or that your fund has not changed in some important way.
- All funds go through good and bad periods of performance. The best funds have more good periods than bad, and switching out of one of these during a bad period is normally a bad idea as you miss out on the good period that follows. On the other hand, sticking with a fund that perpetually underperforms is also a bad idea. The only way to distinguish between these two situations is to do your research.
- Look at your fund's performance in the context of its objectives. If, for example, you are invested in an equity fund which states that you need to expect volatile returns over the short term, then some loss of value should not concern you unduly.
- If your fund's performance seems out of line with its objective and it is lagging its benchmark and other similar funds, check that the reasons that you originally invested are still valid: Has the fund manager changed? Is the fund applying the same investment philosophy that produced its long-term record?
Independent advice
If you are uncertain about what to do, it is worthwhile consulting an independent financial adviser (IFA). An IFA can advise you on the most appropriate action. S/he will encourage you to remain invested during periods of underperformance if this will give you the potential to earn better long-term returns. Good advisers spend time and effort to weed out funds and managers that are not good long-term bets, and help you make switches that save you future losses. (Please see Jeanette Marais' piece, which discusses the merits of good, independent advice).