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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? Read on to learn the characteristics of closing funds, the reasons why they close and the key factors 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. (To learn more, read Open Your Eyes To Closed-End Funds and Uncovering Closed-End Funds.)
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 more rare, 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. (For more on how funds grow and when their size becomes damaging to their performance, see Are Bigger Funds Always Better?)
Open-end funds could also choose to close if they are planning a reorganization. The AIM Global Infrastructure fund, for example, closed its doors to new investors in August 2002 because it planned to roll over into the AIM Global Utilities Fund.
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 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, but for 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. Let's look at when a fund's closure is an indication of problems and when 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. (To read more about management, see Why Fund Managers Risk Too Much and Words From The Wise On Active Management.)
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. (For more details on the odds of picking winning funds, see Can You Pick the Winners at the Mutual Fund Track?)
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