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Fund Spy

The Incredible Shrinking Mutual Fund Universe

Bristlecone Fund, we hardly knew ye.

For your next investment, were you planning on buying E*Trade S&P 500, Kids Fund, Surgeons Diversified Investment, Bristlecone Fund, or PIMCO Fundamental Advantage Tax-Efficient Strategy? Well tough. None of them exist anymore. They've all been liquidated or merged into other funds.

They are not alone. A total of 396 funds have been erased so far this year, compared with 438 in all of last year. On the flip side, new fund creation has slowed dramatically. There have been 156 new funds launched this year, compared with 487 for all of 2008. As a result, we're on pace for the first net drop in total funds since 2002. The figures are for open-end mutual funds excluding ETFs which conversely continue to grow.

Last year's market implosion has naturally led to more destruction and less creation. You may recall that in the fourth quarter of 2008 and the first quarter of 2009, not only were funds depreciating rapidly, they were also getting hit with huge waves of redemptions. This meant that many funds were unprofitable for the fund company. The industry rule of thumb is that you need $100 million in assets to turn a profit on a fund, though I'm sure that varies quite a bit depending on the costs wrapped up in each specific fund.

It's not just reduced asset levels that are driving the drop in funds, though. It's also that fund companies looking at their smallish funds think that it's unlikely they will become profitable anytime soon given the environment. This is why the quality of funds being killed off is a little higher than it has been in the past. The average star rating of eliminated funds this year is 2.51, compared with 2.33 in 2008. In addition, any fund that performed particularly poorly in 2008 could be five or 10 years away from recouping those losses and having a track record that's presentable enough to attract new money.

What's more, fund companies' profits are under tremendous pressure. They've been making layoffs and cutting costs across the board so they're much less likely to stick it out with an unprofitable fund. This also explains at least part of the drop in new fund launches. No one is in a rush to launch a new fund, which could be years away from making a profit and will likely draw very little money for the first year or so as investors have until recently been rather tight with their purse strings.

Creative Destruction in Mutual Funds

YearFunds LaunchedFunds ObsoleteNet Change2009*156395-2392008487438492007524376148200651935016920055243721522004374244130

*Data through June 30, 2009.

A Wide Swath
Poring over the list of 396 ex-funds, what stands out is the diversity. In 2002, nearly all the funds that were snuffed out were growth or tech funds as the market implosion spared value stocks and bonds. But last year's meltdown hit just about everything except Treasury funds, so this year's list comes from a wide variety of categories. In all, 39 municipal-bond funds, 11 intermediate bond funds, 10 conservative-allocation funds, and 11 foreign large-blend funds were wiped out. The biggest numbers were in U.S. large-cap categories, but those are also the biggest groups. This time 29 large-value funds, 38 large-blend funds, and 36 large-growth funds have been eliminated.

Most of the funds being eliminated also have a 'me too' feel to them. Fund companies stretch to have at least one of everything and when performance and/or inflows tell them that funds don't stand out, they dump them.

Is This a Good Thing or a Bad Thing?
The effect on investors of these mergers and liquidations is mixed, but I'd say it's slightly positive overall. The good thing is that a lot of subpar and often high-cost funds are gone. Generally when one fund is merged into another, the surviving fund has lower costs and better management. If a fund is liquidated, the investor can likely find a good fund the second time around.

The downside is twofold. First, some funds are merged into a fund with a different objective that might not suit investors' needs. For example,  Old Mutual Growth , a pure mid-growth fund, and Old Mutual Columbus Circle Technology & Communications  are set to merge into Old Mutual Focused (OAFCX), a large-blend fund. And MainStay Mid Cap Value  is set to be merged into MainStay ICAP Select Equity . It's a big upgrade in quality of management, so many shareholders will be happy, but those who wanted a mid-cap value fund now have a pure large-cap fund with an average market cap of $40 billion.

The other negative is survivorship bias. When crummy funds are eliminated, their records go away. That can make a fund company look better because it won't have the taint of those crummy funds, and it can boost category return averages though usually it's by only a slight amount. Some have overstated the case that investors are misled by the new figures into wrongly concluding a category will produce better returns on average. While it can mess with academic studies, I doubt it does much to investors. After all, who decides to buy a fund by pulling up a table of category returns and deciding that they will buy the mid-growth category because its 10-year returns are 1.2% (not 1.1% if survivorship bias is removed)?

For the record, our calendar year individual fund returns are survivorship-bias free but the rolling period returns are not because it's extremely difficult to take out survivorship bias on a daily basis. In FundInvestor where the returns are monthly, we do have a survivorship-bias free table of category performance.

The real bias factor that can mislead investors is creation bias. That's where a fund shop will incubate five funds, keep those records private, and bring out only the one with the good record so that you never see their goof-ups. That's a practice that I'd like to see come to an end.

Where Are We Headed?
With a huge rally and a spike in fund inflows, I'd imagine that the trend will reverse in 2010, and we'll see net creation of funds. As usual, 90% of the new funds will be forgettable.

I'd also imagine that the pace of ETF launches will continue to be rapid. You have a combined land rush and innovation in ETFs as interest in everything not leveraged continues to grow.



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Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.