Closing of a fund can be bad news, but not always

Your Funds

Your Money

March 14, 2004|By CHARLES JAFFE

SOME INVESTORS have become so disillusioned with the mutual fund industry that when they see something good happen, they're looking for the bad.

That's why some investors are concerned about the increasing number of hot funds that have stopped taking new money from investors.

Truth be told, there is a good and bad side to a fund shutting its doors to new investors, but the relationship isn't cause and effect.

That's why investors should be pleased that Vanguard Group recently closed its Primecap and Capital Opportunities funds, or that T. Rowe Price closed its Small-Cap Stock and High-Yield funds late last month and its Mid-Cap Growth fund in December. Combined, the three T. Rowe Price funds brought in $3.4 billion last year, accounting for 45 percent of the money that flowed into Price in 2003.

Among the other funds that have closed in the past three months: Dodge & Cox Stock, Fidelity Low-Priced Stock, William Blair Small Cap Growth and First Eagle Overseas.

Fund closings are rare - the biggest year ever was 2002, according to Lipper Inc., when 77 mutual funds stopped taking new cash - because financial services firms are not in business to turn away money.

But in each recent closing, management's spoken motivation was to stop asset bloat, where a fund draws in so much money that it can't stay true to its investment objective.

Closing a fund to new investors is not the same as shutting it down. The fund merely stops taking on new accounts (in some cases, investors can get into the fund if it's part of their retirement-savings plan). Some fund firms close funds only to new investors - a so-called "soft close" - while others won't take new money even from existing shareholders.

The best closings occur when the fund plans to shut its doors once assets reach a certain level, or when new sales are cut off without warning.

The dangerous closings occur when a hot fund makes a "last call," allowing investors weeks to rush in, all the while panicking that they might miss out.

Not surprisingly, two out of every three funds closed recently have been small-cap funds, with small stocks one of the hottest asset classes in the past year.

That performance point brings us to the downside of fund closings, namely that funds that close to new investors tend to see a drop-off in performance, according to a 1999 study by Morningstar Inc., the most recent on the subject. Morningstar showed that for every fund where the relative performance improved in the three years after closing, three funds saw performance deteriorate.

Some industry watchers believe that a rash of closings, like the one now seen in small-cap funds, is a sign of a market top, an indicator that small stocks might be running out of steam.

That theory is behind the drop-off in performance. The asset category heats up, driving performance numbers; the returns get investors excited and the individuals throw money at the fund. By the time assets are so big that the fund is closing, the economic cycle that lit a fire under the fund is turning.

"Closing a fund is in an investor's best interest, particularly if it stops asset bloat, which really changes a fund's ability to do what it is intended for," says Stephen M. Savage, editor of the No-Load Fund Analyst newsletter. "If you conclude that closing a fund leads to poor performance - especially if the closing was done quickly and in a way that prevented a huge rush of assets at the end - [it] is completely erroneous.

"The conclusion you can draw when you see a lot of funds closing is the same that you might make when you see a lot of firms creating some new type of fund, which is that when something becomes popular in the fund business, it may be time for the economic cycle to change and you may want to put your money elsewhere."

That does not mean bailing out of closed funds, especially because you won't be able to get back in any time soon, if ever.

Instead, it means considering whether it might be time to change the way you are allocating your new investments. You might close off the flow of assets to the type of fund that has closed.

Says Savage: "It's important to separate the cyclical nature of the asset class from the problems caused by asset bloat. If performance gets worse but the entire asset class is suffering, that's OK. The funds you worry about are the ones that stayed open too long, where they stop performing the way you expect a fund in their asset class to perform."

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