Fact of life: Funds come and go but advisers can't lose track

Important to keep a close eye out for closings and mergers, lest clients be left holding the bag

Dec 5, 2013 @ 11:32 am

By Jeff Benjamin

As much as the mutual fund industry preaches the benefits of buy-and-hold investing, it's alarming how prone the industry is to pulling the rug out from under investors' feet.

The fact is, mutual funds come and go. And they come and go often, which is a reality that financial advisers should not only be aware of, but should be watching for lest their clients are left holding the bag of heavy tax and transaction consequences.

“It's important to not leave a client in a fund that is closing because it is one of the subtle ways in which investors fall short in portfolio expectations, and end up leaking performance,” said Daniel Kern, president and chief investment officer of Advisor Partners.

Fund liquidations and mergers rarely are celebrated by fund companies, and with more than 7,500 funds on the market, a closing can be lost in the shuffle. But the numbers are significant and the shuffle is near constant.

Last year, according to the Investment Company Institute, 628 new funds opened, 296 were liquidated, and 197 were merged into other funds.

The pattern ebbs and flows with a certain degree of predictability. For instance, in 2009, following the carnage of the financial crisis, 501 new funds were launched, but 507 were liquidated and 362 were merged.

Research conducted by Mr. Kern found that only about half the funds that existed in 2002 are still around, and only about a third of the funds that were around five years ago are still in existence.

“The mutual fund industry is not terribly dissimilar from the hedge fund industry, where under performance tends to be liquidated, rather than trying to build it up,” said Geoff Bobroff, a fund industry consultant.

For investors and advisers, fund closings and mergers, which are completely legal, can introduce a host of near- and longer-term issues.

“Sometimes a merged fund could lose some of its tax-loss carry-forwards,” said Russel Kinnel, director of mutual fund research at Morningstar Inc.

Timothy McCarthy, who retired last year as chairman and chief executive of Nikko Asset Management, is writing a book on mutual fund investing and worked with Mr. Kern on a recently published research report.

Mr. McCarthy warns that retail investors are particularly vulnerable to fund closings because institutional money is likely to fly out the door as soon as a closing is announced, increasing transaction costs and expense ratios for the remaining shareholders.

“The pattern leads to more selling pressure and that leads to even more investors heading for the exits,” he said. “In the institutional world, when a fund merges, they might not sell it but they will put it on a watch list, which is something you don't see in the retail world.”

According to Mr. McCarthy and Mr. Kern, this is an area that financial advisers can and should be adding value by paying close attention to funds on the brink of closing or merging.

As veterans of the asset management industry, both acknowledge that they have been responsible for closing funds and admit that fund closings will always be part of the industry.

Part of the problem is that funds come and go along with popular market trends, such as technology stocks in the late 1990s or real estate sector investments up until six years ago.

“When you see a fund that is not able to get assets over $100 million, there is a higher likelihood of it being closed or merged,” said Mr. Kern. “A long stretch of underperformance will also increase the likelihood of failure.”

Another factor that Mr. Kern warns advisers to watch out for is instability at the fund company level, of which there were many examples during the 2001-02 fund industry insider-trading and late-trading scandals.

“Even if some of the individual funds are doing fine, instability at the parent company level can lead to closed funds,” he said.

And, of course, there is the impact of the closely watched fund ratings, including Morningstar's star-rating system.

According to Mr. Kern, it is extremely difficult for a one- or two-star-rated fund to gain additional stars, which often deters investors. That, in turn, leads to closings and mergers.

But as more lower-rated funds drop from the ranks, the industry falls victim to survivorship bias, which effectively improves broad category average performance, and also can turn average-performing funds into the lower relative performers as the worst performers vacate.

Fund mergers are often viewed as the lesser of two evils because it helps the fund company keep the assets in house, and investors are usually moved into a stronger product.

But the risk there is that the new fund could be different enough to alter an investor's portfolio allocation.

“You don't want a fund company to merge away mistakes or sweep things under a rug, but a bigger fund usually means lower expenses,” Mr. Kinnel said. “In aggregate, a merger might not be very good, but it can be good for the investors in a particular fund if a lousy fund is merged into a better fund.”

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