Say you are reading the paper, and you notice that a certain fund will be closing its doors to new investors by the end of the current business day. What exactly does this mean? Should you rush to invest in it, increase your holdings in it or rush to sell? Listed below are the characteristics of closing funds, the reasons why they close, and key factors that you must consider when evaluating a closing fund.
Closed Funds Vs. Closed-End Funds
It is important for us to differentiate between a closed fund and a closed-end fund. Closed-end funds are mutual funds that, at their initial creation, issue a fixed number of shares to the public, which thereafter are structured as stock (actually, a basket of stocks or bonds) that can only be bought or sold through an exchange.
Closed funds are open-end funds that will no longer accept money from new investors (investors who do not currently own any shares in the fund). For closing funds performing a “soft close,” existing shareholders can still buy shares of the fund after its doors have closed to the public. In a “hard close,” which is rarer, a fund does not accept new money from new or existing shareholders.
Why Funds Close
The biggest reason why a mutual fund company will decide to close its fund’s doors is that the fund’s strategy is being threatened by the fund’s size. Funds that tend to outgrow themselves the most are small cap funds or focused funds. When a fund performs well, many new investors are willing to invest their money into it, but because small cap funds deal with low-volume stocks and focused funds prefer portfolios containing only about 20 shares, large amounts of assets will hinder the strategy of either type of fund.
Furthermore, a large influx of cash may compromise the manager’s ease in performing trades. It is much easier for a fund manager to shuffle $500,000 worth of stock than it is to shuffle $10 million worth. The decision to close a fund’s doors to new investors could be to protect existing shareholders from stagnant or declining fund performance. Open-end funds could also choose to close if they are planning a reorganization.
Performance of Funds After Closure
What effect does closure have on the fund’s performance? Well, it’s hard to say, but investors should be aware that some closed funds tend to have a less attractive performance after closure. “Morningstar’s Guide to Mutual Funds,” published in 2003, cites a study in which Morningstar tracks the performance of a group of open-end funds that closed their doors to new investors. The funds in the study were of the top 20% of the funds within their categories prior to closing. However, three years after their closure, 75% of the funds dropped to an average performance.
The lower returns may not necessarily be a direct result of the closure itself, but may instead be a result of the problems the fund was experiencing already before it closed its doors. However, when a fund’s closure is an indication of problems and when is the closure is actually a signal of prudent management.
When It’s Bad News
Many funds do not decide to close their doors to new investors until the fund’s performance has already been damaged by its growth. The agency problem, a conflict of interest that can arise between creditors, shareholders and management because of differing goals, is the main reason many funds do not close their doors sooner. Because fund companies bring in more money (in fees) by attracting investors, a fund’s drive to increase its profitability may keep it open too long. Also, some fund managers’ compensation is tied to the size of the fund, so these managers have the incentive to manage increasing amounts of portfolio assets.
It is important for investors to realize that some closed funds do not perform as well simply because of the normal/overall market conditions. A fund that consistently outperforms the market is a rare find, and over the long run, funds tend to converge to an average rate.
When It’s Good News
The large influx of funds from investors, on the other hand, sometimes indicates the fund manager’s superior skill in picking assets for the portfolio. Some funds, when they are first created, set a limit on the maximum amount of assets they can handle. The closure of this kind of fund is a sign that the fund manager is working to maintain the fund’s original investment goals and the efficiency with which they move the fund’s assets. This fund would see a higher chance of performing well after closure.
The Door Is Shut, but Not Locked Forever
Open-end funds can choose to open and close their doors as they see fit. Consider the Hartford Midcap Fund, which initially closed its doors in September of 2001. Its net asset value at that time was around $15 a unit, a significant drop from the fund’s peak of $23, which occurred at end of the previous year. The downward slope from the $23 peak indicates that the fund manager was starting to have extreme difficulty in maintaining the fund’s mid-cap strategy.
Figure 1
Source: BarChart.com
The fund’s performance regained ground over the next year as a closed fund, only to be reopened again in the summer of 2002, when its performance began to drop again. The fund closed its doors again to investors in the summer of 2003.
Stay In or Get Out?
If you currently hold units of a fund that has announced it will be closing its doors to new investors, do you want to squeeze out through that door, or should you stay? Just because your fund is closing its doors to new investors doesn’t necessarily mean that you should expect to lose money in the future, especially if the closure is a prudent and timely decision.
The Bottom Line
When your fund or prospective fund is closing, knowing the positive and negative implications of the closure is important for deciding what to do, especially because you’ll usually have a short period of time to act. Determining whether the fund is already damaged or whether it’s maintaining its strategy, and therefore saving itself from compromising its goals, should be key when you’re evaluating a fund’s closure. Remember to direct your investments or they will direct you.