December 11, 2013

How Mutual Fund Closings Hurt Investors (and Why Advisors Should Care)

Have you ever thought about what happens to clients’ holdings when a mutual fund goes out of business: that is, gets shut down or merged into another fund? I’ve been covering financial services for 30 years, and I hadn’t. Not really. Like many advisors, I suspect, I’ve always assumed the clients get a check for their holdings at NAV, and buy another fund. Unfortunately, it’s not always that simple.

Fortunately, Daniel Kern and Tim McCarthy have thought about fund closings in great detail: And published their insights in “The Safe Investor: Research Findings,” by Advisor Partners, an investment manager in Walnut Creek, Calif., as part of the research that went into McCarthy’s new book “The Safe Investor.” 

McCarthy and Kern should know what they’re talking about. Dan Kern is currently the chief investment officer of Advisor Partners, and formerly a managing director and fund manager for Charles Schwab Investment Management, and a managing director and principal at Montgomery Asset Management. Tim McCarthy is a past president of Charles Schwab and Co., and the former CEO of Nikko Asset Management. They previewed their findings in Dan’s Nov. 14 blog on ThinkAdvisor (“Will Your Mutual Fund Die Before You Do?”), and presented their findings on Dec. 4, in a webinar produced by Brighttalk.com titled “Mutual Fund Roulette.”

The most striking part of the Advisor Partners' findings is the frequency with which new funds close (which apparently surprised the authors as well: it was not the original thrust of their study). When they looked at mutual funds launched in 2007, slightly more than one-quarter of them were out of business by 2012. Going back five more years, of the funds launched in 2002, only slightly more than half were still operating in 2012. That’s almost an astounding 50% attrition rate over just 10 years—higher even than the turnover for Kardashian husbands.   

If you’re like me, though, the first question that comes to mind is: “So what?” Does it really matter to investors if mutual funds go out of business? As Dan Kern is fond of saying: “Fund closures and mergers are rarely positive for investors.” In the webinar, he and Tim McCarthy pointed out four reasons why investors (and therefore, their advisors) should care about mutual fund closures:

  1. It costs more money to wind down mutual fund holdings. Higher turnover rates drive up trading costs, and higher volumes can hurt trading execution.
  2. They’re selling at the wrong time. As redemptions mount, managers are forced to sell assets to pay off investors, regardless of whether those sales make investment sense or not.
  3. They’re moving out of the market. To lock in current NAVs, many parent companies direct managers to large portions of holdings into cash: which means investors who stay in the fund as long as possible will miss any upward movements in the fund’s asset class.
  4. Managers lose focus. Not only is fund management often transferred, as McCarthy put it, “into the hands of lawyers,” but fund managers themselves often lose focus once they realize their fund is going to be closed down.

Unfortunately, the authors didn’t quantify these costs in funds that have actually shut down. But it’s not hard to see that the combination of these factors could put investors in funds slated for the dustbin at a considerable financial disadvantage. Which raises this question: Just what should advisors do to protect their clients? 

The short answer, of course, is to sell out of a fund before things get ugly. But what should advisors look for in their crystal balls to anticipate a problem? Kern and McCarthy suggest the key is to understand why funds close down, which isn’t rocket science. Most funds close down because performance is poor and low asset volumes make a fund uneconomic to operate. These are both widely tracked data points. 

In truth, many advisors would probably have moved out of the fund already, due to that “poor performance” thing. However, as McCarthy pointed out: “Well-allocated, diversified portfolios are designed to keep from selling out when a particular asset class is down.” Consequently, advisors are often reluctant to sell funds that play a specific role in their allocation: such as emerging market, value or commodity funds. The key, of course, is to watch out for funds that are out of step with their sector—which further illustrates the risk of including sectors covered by only one or two funds in a portfolio. 

The authors also cite the potential for broader problems at a fund’s parent company to force fund closings or consolidations. Yet tracking these issues can be a bit trickier. To simplify identification of potential fund closings, Kern and McCarthy offer a somewhat surprising solution. While they emphasize that the Morningstar “five star ratings” don’t have a very good track record for predicting top performing funds, their “one star rating” is “ a very good indicator of which funds are going to close.” 

While a stickler might wonder whether this is a chicken and egg thing—that is, that some funds might be driven to close because they got a one-star rating—that doesn’t diminish the predictive nature of the low rating.  For advisors, the takeaway from The Safe Investor: Research Findings is that fund closings can hurt portfolio performance—and detecting these closings early creates yet another way they can benefit their clients. 

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