When and how to replace a fund in a portfolio

When crafting a client’s portfolio, have a contingency plan: funds can’t always remain with clients over the long term, perhaps for tax or strategy reasons, and sometimes they terminate.

Aside from termination, a fund can no longer be suitable when its strategy and risk level changes, or when it merges with another product, says Peter Guay, a portfolio manager at PWL Capital in Montreal.

In many cases, you may need to swap that fund for another—ideally, tax-efficiently.

Guay, a discretionary manager, says he can choose from a list of 50 to 70 approved ETFs, all of which have been researched and greenlighted by an investment committee that includes all of the firm’s portfolio managers. A managed account committee dictates what types of funds can be chosen.

Advisors, too, should work with broad, diversified fund lists, says Darren Coleman, senior vice-president and portfolio manager in Toronto at Coleman Wealth, under Raymond James. For contingencies, you can choose “three or four different ways to accomplish the same strategy. You can have a favourite fund as well as some in the wings,” he says. Explaining this practice to clients can help highlight the rigour of your process.

It’s rare to have to replace a fund if you use established, broad-based products, say Guay and Coleman, but here’s what to do if a holding falls out of favour.

How to replace a fund

Before pulling the plug, review potential replacements; consider the funds’ strategies and past performance, and whether they align with yours or your client’s investment strategy and goals, says Guay. Also, confirm the funds are approved by your firm.

During this process, be open to switching providers, he adds. For instance, if you’re holding the iShares Canadian Real Estate Index Fund but want to switch, you could swap it for the Vanguard Canadian Real Estate Index Fund, given “the underlying securities are substantially the same.”

Guay doesn’t switch from one domicile to the next, such as from Canada to the U.S. His U.S. citizen clients hold U.S. funds and his Canadian clients hold domestic funds due to tax considerations. He suggests looking for proxies within the same markets.

The rules

IIROC offers guidance about reviewing, recommending and selling products. One such note says dealers and reps must be proactive about “reviewing and improving their procedures for introducing new products, and for monitoring those that are not new but that have unique and complex features […].”

Further, says IIROC, always identify when changes to a fund affect its “time horizon, potential for loss and expected return or mark-to-market volatility.” That should lead to a review of its suitability.

MFDA advisors must also fulfill suitability requirements. Ian Strulovitch, director of public affairs for MFDA, adds, “Whether additional steps would need to be taken to comply with MFDA requirements would depend upon the reason why the fund was terminated or why the product was taken off the shelf.”

Replacing one fund with another is generally quick and seamless, Guay says, unless you’re dropping a product because it isn’t tax-advantageous any longer.

If he was swapping funds for a client for tax efficiency, the main goal would be to make the switch at the right time, says Guay. “We’ll phase out the old fund over time, waiting for when the tax environment is good and so we don’t trigger gains or losses unnecessarily,” even if the process takes years, he says. “Transitioning in a rushed manner will negate the advantages of the new, better fund.”

One reason to review your fund lineup on a client’s behalf would be changes to the tax environment for certain investments, he adds.

Selling a fund when it’s down doesn’t have to be a disadvantage. If it has lost value but you still need to exit, there’s a tax benefit, says Guay. “If a fund has dropped substantially because the underlying market has gone down, that’s all right; the fund is doing what it’s expected to do. Also, there’s the potential for tax losses that you can harvest” if the fund is held in a non-registered account.

Client communication

For Guay, client communication throughout the process is minimal. “We won’t get into the fine details unless clients ask, because our clients chose discretionary management,” he says. “We do keep people up-to-date on what we’re doing by providing explanations as to why they may see trades in their accounts.”

For non-discretionary managers and advisors, Coleman suggests using such a situation to highlight your value. Clients appreciate knowing that you’re paying attention to details such as when a fund’s strategy or manager changes.

If a fund is closing or merging, tell clients why, he adds (see “A terminating fund”). How much you tell clients will depend on their interest and knowledge level, Coleman says, but be prepared to offer both the short version (where you explain what you did) and the long version (exactly why a fund was affected and your process).

It should be rare for funds to close or merge, triggering portfolio changes. Focus on funds that are established, large and liquid.

When disclosing why you chose a replacement, it matters whether the previous fund failed or the provider is simply changing its lineup based on cost and tax considerations. The focus should be on lessons learned, says Coleman, and whether you’ve determined if a fund closing or merging was a one-off situation or a sign of issues with a certain strategy or area of the market. Coleman points to corporate-class funds, which he used more before the 2016 budget made switching between such funds a taxable event. Now, he uses one corporate-class fund, for its remaining tax benefits, versus switching within a group of four or five.

If you’re dropping a fund that’s lost value, be upfront about the loss, says Coleman. “We never let how a fund has performed dictate what we need to do. People might want to hold on to a fund hoping it comes back, but we have to measure investments based on where they are today,” and whether they’re still suitable. “If they no longer fit, they have to go.”

If your firm removes a fund from its approved list, offer to explain. Clients may want to know how regulatory trends, such as CSA’s proposed reforms regarding proprietary product and advisors’ KYP requirements, affect their holdings.

A terminating fund

When investment funds close, investors are typically given several months’ notice. Before a fund’s termination date, investors will receive written notice outlining the details.

Investors may redeem or switch their holdings to a new fund before the termination date. On the termination date, all outstanding units are redeemed at market value and the proceeds distributed. If investors hold the funds in registered plans, all redemption proceeds remain within those plans unless otherwise requested.

If a fund has lost value by that point, it can result in losses for investors and have tax consequences, says Peter Guay, a portfolio manager at PWL Capital in Montreal. That’s why you want to sell in an orderly fashion, before the fund is officially terminated, and if possible before the fund closure is announced.

Guay adds a few months’ notice is often enough to choose a replacement fund and switch tax-efficiently, but it depends on the situation and why a fund is closing.

When a fund merges, investors go through a similar process, with the option to redeem their units or to switch to the continuing fund. Most fund mergers are done “on a tax-controlled basis,” says Darren Coleman, senior vice-president and portfolio manager in Toronto at Coleman Wealth, under Raymond James. But, if the merge means an investment loses its tax benefits going forward, moving to a new fund may be in order.