Mutual fund investors imagine that their fund managers busy themselves acquiring stocks or bonds to post the best possible investment results.
Increasingly, however, successful fund managers working for large fund organizations must acquire poorly performing mutual funds within the same fund family. The results of these transactions, which pit one group of shareholders against another, are unlikely to be posted.
Last year, 178 classes of equity fund shares were merged into other funds, 37 percent more than in 1997, according to fund researcher Lipper Inc. Industry analysts expect the pace of fund mergers within and across fund companies to increase this year and in the years ahead as consolidation reduces the surfeit of equity funds.
"Wait until the market makes a correction; there's going to be a lot more shakeout," said Narayanan Jayaraman, associate professor of finance at the DuPree College of Management of the Georgia Institute of Technology in Atlanta and one of three co-authors of a study that examined 742 mutual fund mergers from 1994 through 1997.
The reason is simple. Despite relatively good performance by many equity funds against market benchmarks in the second quarter, the well-established tendency of disappointed investors to redeem shares at underperforming funds has created a vicious cycle of weakening performance and reduced assets under management that fund organizations cannot tolerate.
Such organizations "need to remove the funds that have not performed well so they don't affect the overall fund family reputation and fund flow," Jayaraman said.
The answer for a fund organization is to liquidate shrinking, underperforming funds and pay out cash, often with harmful tax consequences for fund shareholders, or merge laggard funds into better-performing funds, thereby flushing out bad track records while retaining assets and fees.
Not everyone escapes unscathed in the process of rubbing out weak funds. Typically, shareholders of a merged equity fund fare better than shareholders of the acquiring fund, the Georgia Tech study concluded.
Two factors -- fund performance and fund size -- are predictors as to whether a fund is likely to be merged out of existence, said Ajay Khorana, assistant professor of finance and a co-author of the study.
A small-capitalization growth fund with a poor investment track record is likely to be merged into another small-cap fund with a better record within the same fund family.
Recently, Chicago-based Stein Roe mutual funds withdrew a proposal to merge its large, underperforming aggressive growth fund, Stein Roe Capital Opportunities, into a newer, smaller fund after the Securities and Exchange Commission ruled that the track record of Capital Opportunities must become the track record of the acquiring fund -- precisely what Stein Roe was trying to avoid.
Generally, however, regulators have given fund companies a free hand in deep-sixing bad funds.
Acquiring funds tend to have beaten their performance benchmarks in the 12 months before and after the merger, but the level of outperformance drops sharply in the subsequent year, the Georgia Tech study found.
"In terms of performance, it doesn't appear that the merger helps the shareholders of the acquiring funds," said Edward Nelling, assistant professor of finance and co-author of the study. "It's kind of hard to think of ways in which it could help them."
In addition to worse investment performance, shareholders of acquiring funds realize no benefit through economies of scale when their fund acquires a laggard fund. "There's no evidence to back that up," Nelling said.
Expense ratios don't decline at the acquiring fund after the merger. Moreover, many studies have shown that larger funds are not necessarily better-performing funds.
On the other hand, "target shareholders from the point of view of expenses and performance tend to benefit," Nelling said. Shareholders of weak-sister funds being merged, especially investors with taxable accounts, have little to lose and much to gain through merger into a better fund rather than liquidation.
At many fund organizations, the directors of the acquiring fund are identical to the directors of the acquired fund. The same individuals must vote from often-conflicting positions.