The Sept. 5 letter to investors of the Legg Mason Market Neutral Trust wasn't pleasant. In large block letters, directors urged investors to vote with management and approve a proposal to liquidate the ailing mutual fund, which was just 19 months old.
"Since the fund commenced operations, it has been slow to attract assets, and it has not performed in a manner that is likely to attract additional assets," the letter stated.
Twenty-four days later, the ballots were cast, and the liquidation began.
The letter, sent out by a unit of Legg Mason Inc., the Baltimore money management and mutual fund company, was not common, considering there are 5,509 mutual funds.
But it is the kind of correspondence that is being dispatched by mutual fund companies with greater frequency in the wake of the stock market's problems and the huge number of funds competing for investors.
The experts say liquidations are on record pace this year.
Already 176 mutual funds have been liquidated, compared with 156 last year, according to Wiesenberger, Thomson Financial, a Rockville fund research service.
"If we are talking purely liquidations, this year will be a record in terms of fund liquidations," says Ramy Shaalan, a mutual funds analyst at Wiesenberger.
The record was set in 1998, when 222 funds were liquidated. Shaalan expects little problem in breaking the record because many funds close in the last three months of the year.
There are a number of reasons why liquidations are rising.
Last year, and earlier this year, there was strong demand for funds that invested in technology, large companies and Internet firms.
But funds that invested in gold, bonds, international companies and small firms were "just shriveling up," says Russel Kinnel, director of fund analysts at Morningstar.
He says it was like "taking a pool table and tilting it and all of the balls ran into one corner."
Much of the money flowed into the largest fund families, and choked smaller companies.
One fund group hurt was the "market neutral" funds, designed for conservative investors who want a steady return.
In theory, the funds should make money in both rising and falling markets, which is why they are so appealing.
They are supposed to do this by investing half of their assets in under-priced stocks that are expected to rise. These holdings are called "long" positions.
The other half of the assets are invested in highly priced stocks that are expected to fall.
The fund shorts these stocks, or bets that they will decline in value, and thus makes money as the price declines.
Legg Mason opened the market neutral fund in February 1999, and through most of the year it "behaved the way it was supposed to behave," says Tal Daley, director of Legg Mason's mutual fund marketing unit. The fund made money when the stock market rose and when it fell.
But the fund held short positions in a number of Internet stocks, betting that their values would sink. Instead, the stocks soared in November and December and into 2000.
"We got crushed on the dot-coms," Daley says. "It overwhelmed the long portfolio. The only thing that can really kill you in a market neutral fund is to have your shorts go up more than your longs."
The fund's assets, which peaked at $19 million in the summer of 1999, plunged to about $6 million by spring.
With such a dramatic swing, Legg Mason's managers concluded that it would be useless trying to persuade investors to stick with the fund.
"It would have taken a long time to rebuild the confidence of the average client," Daley says.
On Sept. 5, Legg Mason's executives sent the letter to shareholders in favor of liquidating the fund.
Investors rushed to take out their money, and the firm pumped $500,000 into the fund to keep it operating.
On Sept. 29, shareholders voted to liquidate the fund, and Legg Mason cut them checks last week, worth nearly 20 percent less than their original investment.
"It is not the end result that we wanted, but it wasn't like they got 10 cents on the dollar," Daley says. "We clearly don't consider this a disaster."
Of course, it was hard for Legg Mason to close the fund because it liked the concept.
But in the mutual fund business, there is little room for error.
"Maybe we just launched this thing too early and got socked by dot-com mania," Daley says. "Maybe if we stuck with it we would have been OK. But would we have still attracted money?"
