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

Christine Benz
Michael Rawson, CFA

Christine Benz: Hi, I'm Christine Benz for

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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Rawson: Naturally, when we select a fund, we look at the funds that have had good performance over historical time frames--let's say five or 10 years. But by selecting the funds that have existed over five or 10 years, we're naturally ignoring those funds that existed five years ago, but didn't make it to today. Those are the funds that closed or were merged away, and those are the ones that had poor performance. So we're inflating our numbers if we look at just the funds that have survived.

It's important to remember that there were some funds that were available to me that I may have chosen that no longer exist today, so the total return number of just the winning funds, the surviving funds, is naturally going to be a little bit better than all funds that were available historically.

Benz: In your study, you took a look at some of the characteristics of funds that were more or less likely to be closed down the line. What were those commonalities? Being small, you said, is one of the biggest predictors, but were there any other things that you looked at?

Rawson: There were a couple of other things. Fees were a predictor. High-fee funds tended to close, and this makes sense because it probably goes somewhat hand-in-hand with assets. If a fund has a small asset base, in order to cover costs, the fund company has to charge a lot as a percentage of those assets, and those funds are less likely to attract flows, and so they're more likely to close.

You also have this tendency where larger fund companies are able to support a fund, and maybe keep it out there, whereas a smaller fund company doesn't have the resources to keep the fund in existence. So some things you want to look out for if you're really concerned about whether a fund will close or not are its assets under management, its fees, its performance, and the stewardship of the fund company overall.

Benz: Another thing you looked at was investment style, and I thought it was curious you noted that growth funds had a higher tendency to be closed or merge away or liquidate than did other styles of funds. Why is that?

Rawson: I think it goes back to active management being so difficult. To find an active manager who can consistently outperform in certain areas is difficult, particularly when it comes to growth investing. Growth is all about change and investing in current trends in the economy, whether it be the Internet or biotechnology or social media. Those trends change over time, and sometimes if a fund doesn't keep up with those changes or predict those changes, its performance may suffer.

So, we tended to see more growth funds closing than value funds. That may also be a result of the fact that value funds are often quantitatively based, maybe dividend strategies, which can withstand the test of time, whereas growth is a little bit harder to predict how it's going to behave over time.

Benz: And we saw a big launch of growth funds in the late 1990s, early 2000s, and a lot of those had terrible performance.

Rawson: That could be the reason right there.

Benz: A logical question is, if these dead funds--and the incorporation of the dead funds--changes the way we look at the data, can Morningstar do anything to address the fact that some of these funds have liquidated, and return rankings and so forth may in fact be different than what investors are actually seeing?

Rawson: Well, it's not easy, because you have to make some assumption about what to do with those dead funds. Morningstar does have numbers which present both views. But for the most part, when you're looking at funds that are available for you today, you don't really care about the funds that closed, because they're closed--you can't pick those anyway. So, you just want to look at funds that are around today.

There is no easy way around the problem. We do have numbers that are survivorship-bias adjusted. We could take the funds that existed in each month and string those returns together. So, it depends upon what you're looking for. If you're concerned about it, you just want to go in with your eyes wide open and understand that you may be looking at a number that is inflated by the fact that some funds have closed.

Benz: How should investors think about survivorship bias when they look across funds or when they are making fund selections? What are the takeaways?

Rawson: One of the takeaways is that it's easy to pick a good fund in hindsight. You look back at the funds that have had success, or the fund companies that have had success offering active management, such as Fidelity or American Funds. Those are companies that have been successful, and that's why they are so big and prominent today. But if you go back 10 or 20 years ago, it wasn't necessarily clear which funds and which fund companies were going to succeed.

Fund companies are only going to present material that puts their funds in a good light, and they're only going to show the funds that have been successful. They're not going to tell you, "Hey by the way, a couple of years ago, we offered a bunch of funds that no longer exist. Don't choose those." Well, you can't choose those. They are only going to show you the good funds.

So it's important to take any fund marketing literature with a grain of salt and always look to a third party, such as Morningstar, which is going to give you an unbiased opinion about the options that are available to you.

Benz: And you also found that index funds, when you looked at them through the lens of survivorship-bias-free data, actually jumped up in the rankings a little bit.

Rawson: They did improve in the rankings, in part because I think index funds tended to have some of those attributes that made them more likely to survive. They tended to be lower in cost. So, they were more likely to survive, and therefore, they would improve in the rankings if you included those dead funds which closed. Relative to those funds, the index funds would have looked a little bit better.

Benz: This is a complicated topic, but an important one. Thank you for being here to talk about it.

Rawson: Thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz for