Are Closed Mutual Funds Better Performers?

Are Closed Mutual Funds Better Performers?
A new study, “Closing and Cloning in Mutual Funds,” from two professors, HsiuLang Chen and Xiaoqing Hu, at the University of Illinois and Sheldon Gao of
Schroders Investment Management looks at the performance of mutual funds
that have been closed to investors, as well as the performance of new funds that
appear to be “cloned” from closed funds and opened to investors. The authors
defined cloned funds as having the same investment objective as the closed
fund, plus sharing at least one fund manager, and defined sibling funds as having
a different investment objective, plus sharing at least one fund manager.
Among US equity funds between January 1995 and December 2004, 238 funds
were closed to new investors. The authors found these funds did not deliver
positive objective- and size-adjusted returns following closure. This is not a new
finding, and the authors cite several previous studies that came to the same
conclusion.
Looking deeper, there were 58 cases where the fund manager cloned a new fund
after closing the original fund, where the new fund had substantially similar
objectives and strategies as the closed fund. In these cases, the closed funds
did not generate significant positive objective- and size-adjusted performance.
However, the closed funds that did not subsequently launch a new fund delivered
significantly positive objective- and size-adjusted returns for up to six months
after fund closure.
Specifically, the key results of the study were:
•
For the six months following fund closure, all closed funds beat their
benchmarks by 1.06%, while those that did not clone new funds beat their
benchmark by 1.63%. Benchmark comparisons were done by identifying
those funds with similar investment objectives, grouping them into
quintiles by fund size, and taking the average performance within each
quintile. These are the objective- and size-adjusted returns referenced
above.
•
For the 12 months following fund closure, cloned funds had no statistically
significant performance advantage over the corresponding closed funds,
as measured by their alphas. They pursued comparable investment
strategies, as indicated by their similar factor loadings (based on the
Fama-French four factor model, including momentum).
•
The average expense ratio for cloned funds is 12 basis points higher than
the funds from which they were cloned.
© Copyright 2007, Advisor Perspectives, Inc. All rights reserved.
•
Closure is an effective non-performance-based mechanism to attract fund
flows. Cloned funds attracted 16.98% of cumulative excess fund flows in
the first six months following launch. When closed funds launch new
sibling funds with a different objective, the figure is even greater---the new
siblings attract additional 24.64% of cumulative excess fund flows relative
to their peers.
The performance of closed funds that cloned new funds has not been studied
before, and the authors cite these findings as new contributions to the literature.
Why Do Fund Companies Close and Clone Funds?
There are many potential reasons why fund companies close mutual funds to
new investors, and the authors looked at whether their data could shed any light
on the relative validity of these explanations. The data on fund closures
suggests that fund performance is “scalable over time,” implying that fund
managers’ abilities to identify superior investment returns does not diminish over
time. This is supported by the finding that closed funds that did not clone new
funds continued to deliver superior performance.
The standard explanation for closing funds is that there is a lack of good
investment opportunities relative to the cash on hand, which usually follows a
period of stellar performance by the fund. However, given the sizable number of
funds cloning new funds, this cannot be the sole explanation.
Another explanation for closing a fund is that there is an optimal fund size; once
a fund exceeds this size it is economically better for fund companies to clone a
new fund rather than allowing the existing one to grow, because of diseconomies
of scale in trading costs and price impact effects. There is also an organizational
effect; small fund companies are likely to outperform larger ones (all else equal)
because of a superior ability to communicate and process soft information.
Marketing enters into play, since shutting a fund to new investors sends a signal
of good governance and a willingness to honor commitments, earning the trust of
existing and potential investors. Greater public attention associated with fund
closures also aids in marketing, and the authors show that new funds launched
by closed funds are able to attract significant higher fund flows than other new
funds. Cloned funds are thus a way to attract new fund flows absent superior
performance, and fund companies are able to charge expense ratios that are, on
average, 12 basis points higher than the corresponding closed funds.
© Copyright 2007, Advisor Perspectives, Inc. All rights reserved.
Lastly, the study shows that closing and cloning occurs more frequently with
smaller funds and with funds with more junior managers in place. Funds are less
likely to clone funds with the same investment objective if the closed fund is in a
‘hot’ investment style. On the other hand, funds are more likely to clone funds
with the same investment objective if the closed fund has more senior managers,
to take advantage of those managers’ superior stock selection skills.
The above explanations are not mutually exclusive and some may have more
power under different market conditions (e.g., bull versus bear markets) and in
different sectors (e.g., hot versus cold).
Implications for Financial Advisors
The key implication for financial advisors is that when new funds with the same
investment objective are cloned from existing closed funds, the closed funds do
not deliver superior performance. The corollary is that closed funds that do not
subsequently launch new funds represent good investments. Cloning funds with
similar investment objectives should be regarded as a sell signal for those
holding the closed fund, and the absence of such actions should be regarded as
a hold signal (assuming you are fortunate enough to already own the closed
fund).
As for investing in a cloned fund, the study shows that clones have performed
statistically similar to the funds from which they cloned (over a 12 month period),
but that neither the closed fund nor the cloned fund has had success in beating
their benchmark.
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© Copyright 2007, Advisor Perspectives, Inc. All rights reserved.