My firm, Advisor Partners, was surprised to discover how many funds fail to stand the test of time. We were led to this discovery after recently completing a research study in connection with a soon-to-be published book, “The Safe Investor,” by Tim McCarthy, the former Nikko Assset Management and Charles Schwab executive. This column is a preview of the study; the full research paper will be released in December.
The initial thrust of the study was performance oriented, as we intended to examine whether top-performing funds over three-, five- and 10-year periods could sustain their performance in subsequent periods. Although research into this topic has been covered in the past by top-tier pension consultants examining institutional performance and by Morningstar covering mutual fund performance, the continuing tendency of institutional and retail investors to chase performance made it relevant for us to update and extend the research.
The study changed dimensions as a result of our early findings. While we identified interesting findings arising from the primary thrust of research, we also identified an intriguing and unexpected set of issues. In reviewing several years of mutual fund data, we found that survivorship of mutual funds was strikingly low and that investors are likely to outlive many of their mutual funds. Consequently, we revised the study to incorporate additional work to cover survivorship issues.
Mutual Fund Survivorship: A Big Problem
We looked at multiple periods of time, finding the same trends in each period. The longest period of time covered was from Jan. 1, 1995, through March 31, 2013. Of the funds in operation in 1995, less than 40% still existed in 2013. The remaining funds were either closed or merged into other funds.
We narrowed our time horizon, examining the 10-year period from the end of 2002 to the end of 2012 in order to closely examine trends between such factors as performance, Morningstar ratings and assets under management. The trends over the 10-year period were similar to those identified over the longer period we evaluated. After five years, nearly one-third of the funds had been closed or merged into other funds; after 10 years, nearly half had been closed or merged.
Industry insiders often view fund closures and mergers as business as usual and downplay the implications for investors. In our view survivorship matters, as fund closures and fund mergers are rarely positive events for investors. At best, closure or merger of a fund is an inconvenience that forces the investor to make a new investment decision. Often the new investment decision is forced at an inopportune time. At worst, the fund closure or merger may lead to adverse consequences. Fund closures and mergers can create tax consequences or transaction costs that the investor doesn’t control. Mergers are typically better than closures, but can still create undesired consequences.
When a fund is merged out of existence, the “surviving” fund is often different than the fund originally purchased. In many cases, additional costs are absorbed by the fund in connection with the merger or closure. If a merger is considered to be in the best interests of shareholders, a test that is relatively easy to meet, some of the reorganization costs may be passed along to the shareholders. When a fund is liquidated, transaction costs associated with the liquidation can reduce the returns of the funds. Often these costs at the individual shareholder level can be relatively small, but any drag on returns in a low-return environment can be meaningful. The transition process often creates hidden costs or inefficiencies for investors, as portfolio managers reposition the fund for closure by raising cash.
In the case of a merger, the portfolio managers often reposition the fund pre-merger to look more like the fund it is merging with, which can create a subtle but meaningful change in the risk and performance profile.
Predicting Survival of Mutual Funds: Four Factors
For investments that are designed to be short term in nature, the tendency of funds to close or merge isn’t a major consideration for an investor. Funds that are purchased for tactical reasons—such as country funds, sector funds, or inverse/leveraged funds—aren’t intended to be held for long periods of time. We’re concerned more with the longevity of funds that are designed to be part of a long-term strategic investment program, as an ill-timed closure or merger may create unintended consequences for the investors. Accordingly, we reviewed historical data to identify patterns among funds that survive compared with funds that fail to meet the test of time. The primary factors we observed included size, performance, star ratings and parent company stability.
Survivability Factor 1: Size
Larger funds are more likely to stay in business, a simple matter of economics. If a fund is profitable the fund management company is more likely to leave it alone! Funds with less than $100 million of assets have a high attrition rate. Large fund companies (those with greater than $100 billion of assets under management) may have even higher hurdle rates, with funds that have less than $250 million in assets potential candidates for closure or merger.
Survivability Factor 2: Performance
Funds with good performance track records are more likely to survive. Funds can survive periods of outperformance, but the longer the stretch of underperformance the higher the risk to the fund. Bottom quartile three- and five-year performance combined with sub-optimal asset levels is at least a yellow light that can indicate that the fund is at risk.
Survivability Factor 3: Star ratings
Our research suggests that the star system is in many respects a stronger proxy for survivorship than it is for identifying future top performing funds. In most asset classes the star system does provide predictive guidance across two dimensions: what losers to avoid and which funds will survive! In many asset classes, one-star funds are shown to be likely to continue to be underperformers, while four- and five- star funds may not be outperformers, but are likely to be survivors. We found that 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 below)
Survivability Factor 4: Parent company stability
The fund’s parent company is an important, but harder to evaluate factor in survivorship. Stable, well-funded parent companies are less likely to be bought, which can lend some stability to a fund complex. Often, when a fund’s parent company is acquired or merges with another fund company, weaker funds are merged or closed in the rationalization process. Size isn’t always a good proxy for parent company stability, as some very large fund companies are incredibly stable and disciplined in their approach while others have launched and closed numerous funds. Some focused small and mid-sized fund companies are among the most stable in the industry.
What to Do if a Fund Is Being Closed or Merged?
In most cases, there is no reason to stick around if a fund is being closed. The fund will incur transaction costs during the liquidation process and in many cases will be managed by distracted portfolio managers who are serving as caretakers under the supervision of a team of lawyers. We’ve observed several examples in our career of funds drifting from their mandate during a wind-down process. Better to leave the fund than risk an unexpected outcome.
The one exception to this rule relates to taxes. If the investor wants to minimize gain realization, it may make sense to delay redemption if doing so converts a short-term gain to long-term status or defers the gain to the next year.
In the event of a fund merger, the decision-making process is different. The key decision involves evaluating whether the merged fund fits your portfolio and is of a quality that you are looking for.