What if Your Mutual Fund Shows You the Door?

As with any troubled relationship, are you staying too long or leaving too fast? What should you do when your mutual fund closes to new investors or merges or simply goes out of business?

Closed to New Investors

There are some very good reasons your fund may choose to close to investors. Rarely does a fund refuse to accept any more investments from anyone, but occasionally a fund will close to “new investors.”

Why?

Perhaps the fund has a limited market focus. For example, if the fund concentrates on small- or microcapitalization stocks or on a segment of a sector, such as green energy com­panies or a specific country or region, there simply may not be enough investment opportunity to absorb and deploy a huge influx of new money. 

Managers may consider that they cannot find enough good oppor­tunities to have a chance at maintaining their performance record or that new money may force them to choose investments that don’t quite fit with their objectives. Some market segments might be so small that a flood of new investment money might actually move the market artificially.
 
Then there are the funds close with, in my humble opinion, a distinct whiff of the smarmy. Often these funds are hugely popular with managers who have a very successful track record. Some have been closed to new investors for five to 10 years. 

But why wouldn’t a fund that “seeks opportunities” in a general market and already has $25 billion to $100 billion or more invested be able to handle an influx? It’s often the case that these funds indeed allow new investments by current share­holders, eliminating younger investors who weren’t in the market 10 years ago, or allow completely new investors to invest as long as they open an account at a specific investment company. 

So, for example, you can’t buy the Vanguard Wel­lington Fund unless you buy it through an account at Vanguard. If you have an account at another brokerage or are working with an investment adviser, you’re out of luck. Maybe the exclusivity creates glamour or maybe it’s an opportunity for a fund company to promote other, similar offerings.
 
This condition ostensibly is to prevent pension managers from moving large sums into the fund in institu­tional buys. It also conveniently prevents investors from working with anyone else but Vanguard or any other parent company, allowing Vanguard to keep the investor captive and keep all the management fees in-house.

These policies allow companies to corral the investor for themselves, and if the portfolio is large enough, to pelt investors with inducements to elect the firm’s in-house management.

If you really want a particular style of fund with a particular investment, it’s not all that difficult to find a fairly comparable fund — check out Morningstar’s “competitors” list found with its analyst reports. This is really only an issue if you’re considering actively managed funds, some balanced funds or sector funds; index funds should be roughly comparable across the board.

Fund Mergers

Sadly, this rarely happens with successful funds. When a fund absorbs another fund, it generally indicates the merged fund wasn’t successful. Perhaps the fund failed to attract enough money to make it viable for the company to maintain. Maybe its performance has been lackluster. Occasionally entire small fund companies are taken over by much larger investment behemoths. 

Should you go along with the transfer or simply sell out and move on? Consider these questions:

• If the fund’s held in a taxable account (i.e., not a retirement account), what are your capital gains, if any, or can you use capital losses to offset gains in other investments? A transfer to a new fund may not trigger a taxable event, so you have to determine whether you can absorb the effects of a sale.
• Does the new fund look as good or better? Would you buy it as a new investment if you were starting your portfolio from scratch?
• Does the new fund fit into your portfolio design? If you were focused on a specific sector or objective, the new fund’s likely to be more broadly based. Does it still meet your asset allocation design?
• What’s the yield? If you invested in the fund for dividend income, will the new fund pay you what you had planned?
• Is the mutual fund company trying to sweep poor performance under the rug by merging with a more successful fund? Just how successful is the surviving fund, or is one terrible fund being buried in a better but still mediocre fund?
• Did you buy into a fund because of a specific manager? Was the fund part of a small group that was the brainchild of the founder? Will there be the same personal vision with a new manager or much larger company?

Because mutual funds in general are more broadly based and diversified than individual stocks, the deci-
sion is a somewhat less troubling or complex one than when individual companies merge or split off. You really don’t know how the new offshoot will perform or whether the merged company will perform better than the previous entity. With mutual funds, absorbing a small fund and simply slotting it into current investments can have less impact, and the parent probably has a good chance of doing what its track record indicates.

But scrutinize the specific strategies of the new versus those of your old fund. A fund that was hyper-
focused on biotech startups isn’t the same as a general health care industry fund. Although the larger fund is probably broader based and less risky, if you bought a fund to emphasize a specific area you believed had high potential, you don’t have the same potential reward with a more diversified — and diluted — fund. 

In this case it might be time to move on to a small selection of individually chosen stocks.

Investment professionals in general like to think of themselves as smart folks, but just because an idea sounds good doesn’t neces­sarily mean it works. Recently, managed payout funds were that “good idea,” but many of them had insufficient returns to support their payouts; instead, investors are getting a return of capital. Some of these funds will certainly go away, merged into more broader-based market funds.

Kerplunk: Defunct

If you’ve somehow been talked into a hedge fund because you were a large investor or the adviser wanted you to believe you were oh, so special, you have a very good chance of the fund closing. For some reason, high-net-worth investors seem to believe they’re being offered the secret sauce when an adviser suggests they invest in these funds. 

But a hedge fund investment is much riskier: They often depend on the star quality of a (previously successful) manager; they’re often quite small (millions, not billions in assets); and they may depend on obscure trading strategies or private investments that are far more risky and unproven than plain vanilla index portfolios.

These funds close at an alarming rate. Estimates vary, but about 10-15% of them go out of business the first year. Within three years, about a third fail. Their average lifespan is about five years, The Financial Times says. In a bad market, they fall like fumigated bedbugs. Some scramble away and resurface, so it’s important to know your managers and their history. But, as with all managers of active funds, the past is no guarantee of the future.

“About 10-15% of hedge funds go out of business the first year. Within three years, about a third fail.”

How you evaluate regular mutual funds goes double for hedge funds — watch the fees you’ll be charged (frequently over 2%), whether the manager gets a share of any profits and whether the funds can be publicly traded. If they’re not publicly traded, your investment is worth whatever the company says it is — until you try to liquidate. Be sure you understand what it might take to get out of such a fund.

A fund going belly up, the so- called decision to return capital to the investor, can have tax consequences as well. If you should be so lucky as to have a capital gain, you may be liable for a surprisingly large tax bill. If it’s a loss and you don’t have gains against which to offset, you may need a long lifespan to keep deducting $3,000 a year against ordinary income. It’s even worse if the loss comes in a retirement account — you won’t be able to deduct it at all.

It’s much rarer for a fund sponsored by a large investment house to become defunct. Usually poor performing funds will be merged into another, better performing fund in the house’s stable. They won’t want to lose the investor’s business.

Unquestionably, these mutual fund events are going to force you to reevaluate the relationships in your portfolio. Whether or not you in­tended to clean house, any of these changes give you an opportunity to freshen and redesign your investment strategy.

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