Why Great Funds Need to Close

Recently Morningstar's mutual fund analysts have been calling for high-profile funds to close to new investors with increasing frequency. Christine Benz recommended that Fidelity close  Fidelity Dividend Growth (FDGFX) this April and  Fidelity Mid-Cap Stock (FMCSX) in June. In June, Kunal Kapoor suggested that  Ariel Fund (ARGFX) stop taking money from new investors, and Bridget Hughes said the same of  Vanguard International Explorer (VINEX) in July. Paul Herbert probably took the most noteworthy stand. He suggested in May that Capital Research and Management outline a plan to close  American Funds Growth Fund of America (AGTHX)--one the most popular funds ever.

Given this recent history, we thought it a good time to explain again what we mean when we call for a fund to close and why we do so. There are basically two types of fund closures. In a so-called "soft close" a fund stops accepting money from new investors--those who don't yet own the fund. In a soft close, current shareowners can continue to add to their holdings. In the more extreme and rare "hard close," nobody is allowed to contribute more money to a fund. In general, when we call on funds to shutter their doors to new investors, we're suggesting a soft close. (Although on occasion we think a hard close is in order--witness Laura Lutton's suggestion in May that  Fidelity Low-Priced Stock (FLPSX) stop accepting money altogether.) The primary reason we call for funds to close is to stave off the ravages of what we call "asset bloat."

The worst effect of the asset bloat phenomenon is simple: The more money a fund has in it, the less nimble it becomes. If a fund's asset base increases too much, its character necessarily changes. Think in nautical terms: Smaller funds are quick and easy to maneuver, like speedboats, but big funds are more like cruise ships. And no matter how skilled the skipper, speedboats can do things that cruise ships cannot. The most notorious such case is  Fidelity Magellan (FMAGX), which swelled from a $22 million small-cap fund in 1977 when Peter Lynch arrived to the $65 billion mega-cap fund it is today. Of course, that's an extreme example.

More often, asset bloat is less dramatic. Most funds don't move all the way from owning mainly small caps to mainly large caps, but rather see their average market cap increase slowly and gradually--the now-closed  Buffalo Small Cap (BUFSX) is one such example. Others are able to keep their average market caps in the same general range, but they spread assets through an increasing number of holdings:  Meridian Value (MVALX) and  Fidelity International Small Cap (FISMX) come to mind. In cases like these, where asset bloat is gradual and moderate, investors don't need to fear a Magellan-like transmogrification so much as they can expect somewhat degraded performance. Think of an athlete who lets himself get a bit too flabby to compete with lean, mean peers.

When Morningstar analysts see a good fund's asset base increasing rapidly or significantly we really concern ourselves with the best interests of only one constituency: current fund owners.  A fund's current investors provided the capital that drove the fund's success, and they deserve to continue reaping the rewards that they've financed. We're frankly not concerned with future potential fund owners who could "miss out" on owning a great fund, and we're definitely not concerned with the effect that a closure will have on a fund company.

When a fund closes, the shop running it reduces the revenue stream it stands to gain from it. The bigger a fund is, the more money flows through the expense ratio to the firm. As we've pointed out before, fund firms have an inherent conflict of interest between those who invest in the asset management business (the firm) and those who invest in the funds. That's one of the crucial reasons that we like to see fund family executives and fund managers own shares in the fund instead of--or at least in addition to--shares in the firm. If such persons own the funds, their interests are more aligned with fund shareowners and they're more likely to protect fund shareowners. It's also why we dislike the practice of tying a fund manager's annual bonus to asset growth rather than performance: It gives the fund manager an incentive to let assets grow, potentially hurting fund shareowners' interests.

That said, we don't see calling for a fund to close as a shot across a fund shop's bow. We see it as a reminder to asset managers that their most important duty is to their fund shareowners. It's worth mentioning that we can't remember a time when we called for a mediocre or poor fund to close; we don't call for a firm to restrict inflows unless we respect the investment skill in place at the fund. We hold the greatest respect, though, for those shops who routinely close funds early, carefully limiting the pool of lucky investors who have access to their skills. Such firms--most notably Bridgeway, Wasatch, and Longleaf--need no reminders from us, for they demonstrate repeatedly that they keep shareowners interests' paramount at all times.