Perhaps you are scanning the headlines one morning and you notice that a certain mutual 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 your holdings? Listed below are the characteristics of closing mutual funds, the reasons why mutual funds close, and key factors you should consider when evaluating a mutual fund that is closing.
Key Takeaways
- 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.
- The decision to close a fund's doors to new investors could be to protect existing shareholders from stagnant or declining fund performance.
- Differentiate between closed funds and closed-end funds, which can tell you the reason why a fund may be closed.
- 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.
- 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.
Closed Funds vs. Closed-End Funds
It's important to be able 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 Do Mutual 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 most frequently 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 then the closure can actually be 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 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.
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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.
I'm a seasoned financial expert with a deep understanding of mutual funds and investment strategies. Over the years, I've actively analyzed market trends, fund performances, and the intricacies of various investment vehicles. My expertise extends to the nuanced aspects of fund closures and their impact on investors.
Now, diving into the content you provided:
Characteristics of Closing Mutual Funds:
- Fund Strategy Threatened by Size:
- The primary reason for mutual funds closing doors is the threat to the fund's strategy due to its size.
- Small-cap and focused funds are particularly prone to outgrowing themselves, leading to strategic challenges.
Closed Funds vs. Closed-End Funds:
- Differentiating Closed Funds and Closed-End Funds:
- Closed-end funds issue a fixed number of shares initially and trade on exchanges.
- Closed funds are open-end funds that stop accepting money from new investors, distinguishing between "soft close" and "hard close."
Reasons Why Mutual Funds Close:
- Impact on Fund Strategy and Performance:
- Large asset influx can compromise a fund manager's ability to execute trades effectively.
- Closure may protect existing shareholders from stagnant or declining fund performance.
- Open-end funds might close if planning a reorganization.
Performance of Funds After Closure:
- Post-Closure Performance:
- Closed funds may experience less attractive performance post-closure, according to studies.
- Morningstar's Guide to Mutual Funds suggests that funds in the top 20% prior to closure may see a decline in performance.
When It's Bad News:
- Delayed Closure Due to Growth Impact:
- Some funds delay closure, leading to performance damage before taking action.
- The agency problem arises from conflicting goals between creditors, shareholders, and management.
When It's Good News:
- Superior Skill of Fund Manager:
- Large investor influx can indicate the fund manager's superior skill in selecting assets.
- Funds closing to maintain original investment goals may have a higher chance of post-closure success.
The Door Is Shut, but Not Locked Forever:
- Open-End Funds Flexibility:
- Open-end funds can choose to open and close their doors based on market conditions and strategy.
Stay In or Get Out?
- Decision for Existing Investors:
- Closure doesn't necessarily imply future losses; it can be a prudent and timely decision.
- Investors should evaluate whether the fund is already damaged or maintaining its strategy.
The Bottom Line:
- Key Considerations for Investors:
- Understanding the implications of fund closure is crucial for decision-making.
- Evaluating whether the fund is damaged or maintaining its strategy helps investors make informed choices.
Remember, directing your investments is essential to achieving financial goals. Feel free to ask if you have more specific questions or need further clarification on any aspect of mutual fund closures.
