Behind a Fund's Velvet Rope

When a mutual fund closes itself to new money, is it a good thing or a bad thing?

QUESTION: When a mutual fund closes itself to new money, is it a good thing or a bad thing?

ANSWER: Few issues in the investing world are black and white. Sometimes a fund closure can be a good thing; other times, it can be bad. Let us explain.

The common perception is that funds close their doors to new money when they're on a roll and eager investors are wildly throwing money their way. And that's often the case. When managers are inundated with more money than they can handle, they sometimes decide -- with the permission of the fund's board -- to close the fund to new investors, or, in extreme cases, to stop accepting money even from existing investors, in order to control the fund better.

But sometimes funds are closed off simply because of bloat. While fund companies certainly don't want to turn away new investors -- and the fees they bring -- they don't want a fund's returns to suffer because of its unwieldiness, either. Believe it or not, that's entirely possible.

Swelling assets are most problematic for small-cap and micro-cap funds, as well as real-estate funds, which generally buy relatively small real-estate investment trusts. Consider that a $500 million fund must invest $25 million in order to create a position that accounts for 5% of its assets. If the fund grows to $1 billion, that 5% stake rises to $50 million. Such large positions could wreak havoc on the stock prices of companies with market caps of only a few billion dollars or less. A manager might even be forced to seek out midcap stocks to add stability to the portfolio, causing the fund's style to drift.

As a result, fund analysts applaud small-cap managers who shut their doors before assets get out of control -- and the earlier the shutting, the louder the applause. Three out of six equity portfolios at Wasatch Funds, for example, are closed to new investors, and for a period last year, Wasatch Micro Cap (WMICX) even stopped accepting money from existing shareholders, notes Peter Di Teresa, senior analyst at fund-tracker Morningstar. A similar mindset exists at Bridgeway Funds, where four of its seven funds are closed -- two to new investors, and two to all new money.

But while closing a fund's doors might be good for managers trying to stick to their strategies, it isn't always great for existing shareholders. An August 1999 Morningstar study showed that returns often suffer after a fund closes. When the test group's preclosure, three-year annualized return was compared with its performance three years after its closing date, the average return had fallen by about four percentage points. Di Teresa points out, however, that funds that have had to close their doors might suffer afterward simply because their once-successful style has lost some steam. In order to put the situation in proper context, he says, it's best to check the fund's post-closure performance against its peer group to see if it has stayed ahead of the pack.

The Morningstar study also noted that within its test group, tax-efficiency fell five percentage points after a fund's closing date. That's because a static number of investors found themselves shouldering a growing amount of capital-gains distributions. If you hold a tax-sheltered account, such as an IRA or 401(k), this probably isn't an issue. But it could be trouble if your fund is taxable and has exhibited a tendency to produce gains in the past.

So if your fund is about to close, you should look long and hard at its portfolio. If you still like what you see -- and are willing to weather possible lower returns or higher taxes -- hang in there. Similarly, if you're thinking of buying shares before it closes, make sure it's the right investment for you, and that you aren't just drawn to a shining star. "A lot of investors have the psychological feeling that they don't want to be left out of a good thing," says Jeff Tjornehoj, research analyst at fund-tracking firm Lipper. "Closing to new investors is like being kept behind the velvet rope." Trouble is, the other side might not be that thrilling after all.

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