Performance May Take a Hit

In a study, Morningstar examined the performance of funds that closed during a 15-year period. Specifically, it measured performance in the three-year periods before and after the fund's closing. We define "closed" as barring new investors. Most closed funds allow existing shareholders to send more money, however, so closed funds often continue to get big inflows after closing.

The results

For every fund that saw its relative performance improve, three more suffered a decline in the three years after they closed. On average, closed funds' returns relative to their peer groups fell from top quintile in the three years before their closings to slightly below average in the three years after.

What it means

Does that mean closing a fund actually does damage? No. In fact, the performance slump probably has little to do with closing. The explanation is simply that hot funds usually cool off. While a fund may get steady inflows over most of its life, the point at which it closes is usually when inflows become a torrent. And that almost always happens when a fund's strategy or asset class is generating abnormally high returns. Pick any strategy that's producing big returns for a stretch, and it's a good bet performance will slide back to average or worse over the following period.

Scores of technology-laden mutual funds closed in the late 1990s and early 2000s, for example, shortly before the dotcom bust. Investors rushed the doors because they were attracted to the funds' astronomical gains, in some cases higher than 100% in a single year. But those big gains were a red flag that technology-stock prices had reached unrealistic levels. Many just-closed closed funds went down in flames shortly thereafter.

The lesson?

The general performance drop-off for closed funds stands more as further evidence against chasing short-term performance than as an argument against closing. Still, it's sobering to know that a fund's best days are often behind it by the time it closes.

Another reason why closed funds may produce sluggish performance is that fund companies fail to close funds until performance hits the skids or assets are gargantuan. By then, it's too late. If performance is already slumping, then it may be a sign it should have closed billions of dollars ago. Closing off new investment won't slim a fund down to its playing weight from its glory days.