Madison Sargis

In Morningstar Inc.’s latest research, we wanted to better understand fund closures and their impact on investment strategy.  

Our study sought to explain factors leading to fund liquidations and mergers, so that we can recognize funds that should be closed down but are currently still alive. In doing so, we can help investors filter out the bottom portion of the investable universe for individuals looking for long-term vehicles as part of their investment strategy.

What causes fund closure?

The main conclusion of our paper is simple: Funds become obsolete because they do not generate enough value for their investors and do not have enough assets to sustain the operational costs of running the fund. Investors should be wary of such funds currently exhibiting characteristics such as underperformance, low fees, and high outflows. On the other hand, popularity—at the firm and category level—plays an outsized role in dictating fund survival. Funds from unpopular categories and funds from firms who have high historical rates of closure are at higher risk of becoming obsolete.

How do funds avoid closure?

In the U.S., high-fee funds have been less likely to close than lower-fee funds. That’s with all else being equal. At a first glance, this idea seems wrong. But let's think about who’s actually in charge of the process of closing down funds: the firm. Shutting a fund down can be time-consuming, painful, and costly. So if a fund is unsuccessful, investors can vote with their feet and exit a fund on their own. Yet, if a high-fee fund still has enough assets under management to maintain profitability, why would the firm willingly sustain the cost of shutting down a fund? A high-fee fund is more likely to generate income for the firm than a low-fee fund, especially after holding growth rates and assets constant. Therefore, the lower risk of closure for a more-expensive fund makes sense. The firm may not market it, sell it, or put much effort into maintaining the investment, but they will be less prone to shut it down. As a result, more high-fee funds are kept open, after all else is considered.

What’s the impact of fund closures on investors’ investment strategies?

The outcome of this study coalesces around one central point: The fear of closure may be misplaced. For many investors, fund closure itself is not the problem. It is events preceding closure—the outflows, the liquidations, the underperformance—that tend to harm investors. Furthermore, this paper is evidence that fund closures are often forecastable. Funds tend to leave a trail of signals that closure is inevitable. These signals start tend to start appearing six months to two years out, perhaps even longer.

The headache an investor may face is not closure itself, but deciding whether to act on the information that a fund closure is pending. Acting means they must consider replacing the fund. Not acting means they ride out the looming fund liquidation. Either option has unavoidable consequences. Mergers will likely alter the portfolio's investment allocation. Replacing the funds will likely result in due-diligence costs. Liquidations may cause a hefty tax bill and a period of sustained underperformance.

How is Morningstar working to help investors?

At Morningstar Inc., we have the data to help investors identify potential fund closures. By turning such findings into analytics, we can help investors monitor their portfolio to better understand when a holding becomes at risk, so they can make an educated decision for investing in the long term.