Closings slow inflows, our research shows, but their impact on performance is a little less clear.
This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.
On Jan. 16, 2004, one of the very best mutual funds around, Dodge & Cox Stock
A few months earlier, Wasatch Ultra Growth
As the example illustrates, fund closings can lead to dramatically different flows and returns. Thus, investors have to evaluate each closing on the particular facts of the case. However, we now have enough data on closed funds that we can draw some generalizations.
I looked at 200 closings from the past 10 years to get answers to three questions.
In general, I found closing is an effective tool provided that the fund company doesn't wait too long to close.
Why Funds Close
Depending upon analyst and manager resources and a fund's strategy, each fund has an asset capacity limit. If a manager goes beyond that limit, a fund's trading costs can go up and/or the manager can be forced to alter his or her strategy in ways that could hurt performance.
For example, a manager might be forced to hold cash, add more holdings to sop up asset inflows, or venture into larger-cap stocks. Those with foresight close well ahead of that limit so that even if the fund does get more inflows, it won't be a problem. On rare occasions funds will close because management can't find many attractive investments and doesn't want to dilute fundholders by building the cash stake. Funds also close to slow the rate of inflows even if the overall level of assets is manageable. Small-cap funds in particular can be vulnerable to big flows because it's not easy to invest a lot in small caps quickly.
The Link between Assets and Returns
Looking at returns and assets is a tricky thing. They have an impact on each other, so it's not easy to separate cause from effect. Clearly, performance draws assets. In the example at the beginning, Dodge & Cox's continued strong performance drew more assets--it wasn't that the assets spurred returns. Likewise, the Wasatch fund's slump played a role in redemptions more than the other way around.
However, flows can also have an impact on performance. In the short run, the impact of inflows is neutral to positive. It can be positive because a manager will put new money to work in existing positions, possibly driving up the prices of securities in the short run. (That's particularly likely at a small-cap fund, where liquidity in securities is limited.) In the long run, though, asset size and inflows are a handicap. They drive up trading costs, force managers to hold more stocks, and limit a manager's ability to invest in smaller stocks. To be clear, that impact tends to drive performance more toward the category average rather than destroy returns, so the impact is a subtle one.