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By Christine Benz and Michael Rawson, CFA | 08-20-2014 11:00 AM

Don't Forget the Funds That Didn't Make It

As liquidated or merged funds fall off the record, fund category returns and fund company literature don't tell the whole story.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

How do dead funds affect mutual fund performance statistics? Joining me to discuss that topic is Michael Rawson. He is a manager research analyst with Morningstar.

Mike, thank you so much for being here.

Michael Rawson: Thanks for having me, Christine.

Benz: Mike let's talk about why funds close. What are the key catalysts?

Rawson: The main reason is that the asset base is just very small, and so it's not profitable for the fund company to continue to manage and offer that fund.

There are some other reasons, too. One of them is poor performance, which typically leads to outflows, and then the asset base shrinks. So, having a small asset base is a main concern.

Benz: It's not economically profitable for the fund company to keep it going.

There are two main things that can happen if a fund closes. You can either have a liquidation, where they give shareholders their money back, or the fund can merge with something else. Let's talk about the logistics of that, and what shareholders experience? Is it a good thing if a fund closes?

Rawson: It's not a good thing, but it's important not to panic, either. You're not losing your investment; you're getting your money back, the net asset value. You may have some loss of principal. You may have had poor returns. But you're going to get the net asset value back, either through a liquidation, where you're going to get the cash back, or your fund is going to merge in a pro rata basis with another fund.

The problem with that is, if you get the cash back, now you have to all the sudden redeploy that cash. You have to do the due diligence homework all over again. And if that fund merges with another fund, it may not merge into a very similar fund. It may merge into a fund in a different category or at a higher expense ratio. Again you're going back to doing due diligence.

There also could be tax implications. The liquidating fund is selling out of your securities, so if there is a capital gain, you may be forced to pay taxes on that. So it can be what I would characterize as an inconvenience. It's not the end of the world, but it is inconvenient.

Benz: You recently did a study where you looked at the fact that these funds are going away periodically. That has big implications for funds' performance rankings. Let's talk about how that works, and why there are repercussions when you're looking at funds' returns.

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