Tim McCarthy’s recently released book, “The Safe Investor,” included research that my colleague Gerard Cronin and I completed last year. Our most noteworthy finding, presented in a prior ThinkAdvisor column, was that mutual funds disappear at an alarming rate. We recently completed follow-up research to systematically examine the performance of funds in their final months of operation before merging or closing.
But as a reminder, our original research looked at multiple periods of time, finding the same trends in each period. For example, Table 1 illustrates that of the funds in operation in 1998, less than half still existed in 2013. The remaining funds were either closed or merged into other funds.
We also discussed the relationship between Morningstar ratings and fund survivorship. Four- and five- star ratings may not offer predictive guidance for future performance, but may be helpful in distinguishing between funds that are likely to close and funds that are likely to be survivors: 90% of funds that had a five-star rating in 2002 were still in existence in 2007, 78% in 2012. In stark contrast, 63% of funds that had a one-star rating in 2002 were still in existence in 2007, only 39% in 2012 (see Table 2).
In our view, survivorship matters, as fund closures and mergers are rarely positive events for investors. When a fund is closed or merged out of existence, there are very real direct and indirect costs imposed on the fund’s investors. When asked to quantify the impact of fund closures and mergers, we’ve cited observations from prior closures.
One such example was the Laudus Rosenberg Large Cap Value Fund, which lagged its benchmark by nearly 5% in its final quarter of operations in 2009, following a run of almost 6% under-performance in the prior 12 months leading up to its closure. Another such example was the PBHG Core Growth Fund, which trailed its peer group by more than 10% and its benchmark by more than 15% in the years leading up to its closure.
How Closing Funds Perform
So what does our follow-up research on the performance of funds in their final months of operation show?
For this next phase of research, we collected data on 369 funds that closed in 2013. Of that total, 118 were merged into other funds and 251 were liquidated. Our hypothesis was that category rank and category relative performance would get worse as the final days of these funds approached. We looked at changes in category rank as well as changes in the funds’ returns versus the peer group average return.
We compared rank and returns in the last six months of the fund to the prior six months. We also compared rank and returns for the last 12 months of the fund’s life to that of the prior twelve months. Findings were similar for both time frames, so we will focus on the 12-month comparison for the sake of simplicity.
Broad Findings: Closing Funds Were Laggards
On average the closing funds were lagging relative to their peer groups, which may be part of why they were scheduled for closure.
On average, funds slated for merger were ranked 62 out of 100 and underperformed their category average by -1.7% in the initial twelve months. Funds to be liquidated were ranked 65 out of 100 and underperformed their category average by -2.6%.
Surprisingly, we found that the merging funds actually improved as their merger date approached. We suspect this is because they were being transitioned to the presumably superior funds into which they were to be merged. Even so, in their last 12 months, these were still under-performing their categories, ranked 57 out of 100 and under-performing by -0.7%.
On average, liquidating funds saw relative performance decline further as their liquidation date approached. In their last 12 months, these funds average rank dropped to 66 out of 100 and relative under-performance dropped to -2.9%.
There are a variety of plausible explanations for these performance declines. When a fund is liquidated, there can be a very direct impact from transaction costs associated with the liquidation. In many cases, there are additional costs that the fund may absorb in connection with the merger or closure. Less transparently, there may also be performance drag connected to distracted portfolio managers who are serving as caretakers under the supervision of a team of lawyers.
Specific Findings: Don’t Stick to Fund to Its Bitter End
Some of the worst results were truly horrible. In the Long/Short Equity category, the Thesis Flexible fund’s rank dropped 78 points and relative performance dropped by almost 21% year-to-year before being liquidated. In the World Stock category, the American Beacon Zebra Global Equity fund’s rank also dropped 78 points and relative performance dropped by 11% year-to-year before being liquidated.
In the Large Growth category, the Guggenheim Large Cap Concentrated Growth fund’s rank dropped 93 points and relative performance dropped by 6% year-to-year before being liquidated.
These examples illustrate how steep the costs can be for shareholders who stick with a fund to the bitter end.