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Course 409
Chasing Closing Funds

Introduction

We've all done it. There's a bank of six elevators, yet we'll risk life, limb, and cups of coffee to board the one whose doors are closing. Heaven forbid we wait a whole 10 seconds for the next one to arrive.

Fund investors do the same thing. They hear that a fund is going to stop accepting money from new investors in a few days, weeks, or months, and they immediately write a check, as if there's no other fund that could possibly meet their needs.

Of course, fund closings have their merits. Funds close so their managers can continue to invest in their given styles; too many assets can force managers to compromise their strategies. Morningstar data also show that fund closings can help save investors from their own worst performance-chasing tendencies. If a fund closes pre-emptively, before the manager is forced to put new assets to work in stocks that are overpriced, it will protect both current and prospective investors.

As shareholder-friendly as closings can be, however, there's no evidence that rushing the doors of a soon-to-close fund is a good idea. Here's why fund closings aren't always the magic elixirs they are cracked up to be.

Performance May Take a Hit

In a study, Morningstar examined the performance of funds that closed during a 15-year period. Specifically, we measured performance in the three-year periods before and after the fund's closing. We define closed as barring new investors. Most closed funds allow existing shareholders to send more money, however, so closed funds often continue to get big inflows after closing.

For every fund that saw its relative performance improve, three more suffered a decline in the three years after they closed. On average, closed funds' returns relative to their peer groups fell from top quintile in the three years before their closings to slightly below average in the three years after.

Does that mean closing a fund actually does damage? No. In fact, the performance slump probably has little to do with closing. The explanation is simply that hot funds usually cool off. While a fund may get steady inflows over most of its life, the point at which it closes is usually when inflows become a torrent. And that almost always happens when a fund's strategy or asset class is generating abnormally high returns. Pick any strategy that's producing big returns for a stretch, and it's a good bet performance will slide back to average or worse over the following period.

Scores of technology-laden mutual funds closed in the late 1990s and early 2000s, for example, shortly before the dotcom bust. Investors rushed the doors because they were attracted to the funds' astronomical gains, in some cases higher than 100% in a single year. But those big gains were a red flag that technology-stock prices had reached unrealistic levels. Many just-closed closed funds, such as several from Janus, went down in flames shortly thereafter.

The general performance drop-off for closed funds stands more as further evidence against chasing short-term performance than as an argument against closing. Still, it's sobering to know that a fund's best days are often behind it by the time it closes.

Another reason why closed funds may produce sluggish performance is that fund companies fail to close funds until performance hits the skids or assets are gargantuan. By then, it's too late. If performance is already slumping, then it may be a sign it should have closed billions of dollars ago. Closing off new investment won't slim a fund down to its playing weight from its glory days.

...and Taxes Can Make It Worse

Performance isn't the only factor to bear in mind before rushing the doors of a fund that's about to close. The tax efficiency of closed funds may slump, too. Unlike the drop in performance, however, declining tax efficiency is attributable to the closing itself. While inflows can make trading more difficult, they have a positive effect on tax efficiency. They reduce the tax burden on all shareholders because there are more shareholders to distribute capital gains across. It's worth noting, though, that tax considerations have played a part in at least one fund company's decision-making process on closing funds. Vanguard has closed a few funds from time to time, including Primecap VPMCX, but it has left a number of big funds open. Vanguard officials say that the negative tax consequences of closing outweigh the pluses. Rather than close funds such as Explorer VEXPX, Vanguard has added more managers.

Is Closing Bad, Then?

Closing a fund can enable a manager to stick with the investment strategy that has brought him or her success in the past: Excessive assets may force a change in strategy, a problem we'll explore in greater detail later. Closing is still probably worthwhile for funds with a small number of managers and analysts, a strategy sensitive to asset size, such as high-turnover momentum investing, or a fund that focuses on a less liquid asset class, such as small caps or real estate investment trusts (REITs).

Moreover, a number of fund companies have developed what appear to be effective game plans for closing new funds even before they are rolled out. They make their own estimate of what asset size would be appropriate for the fund and sometimes even make a public pledge to close when assets hit a certain level. (Most of these funds closed before they built a three-year record and were thus excluded from our study of closed funds' performance.) Wasatch serves as a good example of this. Through the years, this small-cap boutique has paid strict attention to fund size to ward against asset bloat, and at various points in time, very few of the firm's offerings have been open to new investors. That vigilance appears to have paid off as Wasatch funds' stellar performance through the years owes at least partly to their manageable size.

Wait. And Other Helpful Hints

Many of the funds that have closed at some point in the past 20 years have later reopened. Fidelity Low-Priced Stock FLPSX has closed a few times, or restricted purchase to certain investors, but then reopened at a later date. The same hot money that forces sizzling funds to shut sometimes flees the fund when performance cools, leading funds to reopen their doors. In fact, reopening might be a sign that an asset class is being overlooked and is worth a second look.

Besides watching for reopened funds, keep an eye out for new funds that promise to close at a point when they still have reasonably sized asset bases. But you still need to make sure that it has all the basics of a good fund: strong management, a good strategy, and low costs. If it doesn't, take a pass. There are thousands of open funds, and at least a few ought to meet your needs.

Quiz 409
There is only one correct answer to each question.

1 Which is not true about most funds after they close?
a. Their returns may slow down.
b. Their tax efficiency improves.
c. Their tax efficiency may worsen.
2 Why might a closed fund's returns slow down after a closing?
a. Because closings are bad.
b. Because funds that close are usually experiencing abnormally high returns that must eventually come back down to earth.
c. Because there's no new money coming in.
3 Closings work best for which types of funds?
a. Funds that traffic in illiquid securities such as micro- and small-cap stocks.
b. Large-company funds.
c. Foreign funds.
4 If a fund is going to close, what's the best way to do it?
a. Announce a target asset size and close when it reaches that target.
b. Close once assets top $10 billion.
c. Close once inflows become unmanageable.
5 It's best to:
a. Buy a fund before it closes.
b. Buy a fund after it reopens.
c. Sell a fund if it reopens.
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