How Mutual Fund Closings Hurt Investors (and Why Advisors Should Care)

Unfortunately, the authors didn't quantify these costs in funds that have actually shut down. But it's not hard to see that the combination of these factors could put investors in funds slated for the dustbin at a considerable financial disadvantage. Which raises this question: Just what should advisors do to protect their clients? 

The short answer, of course, is to sell out of a fund before things get ugly. But what should advisors look for in their crystal balls to anticipate a problem? Kern and McCarthy suggest the key is to understand why funds close down, which isn't rocket science. Most funds close down because performance is poor and low asset volumes make a fund uneconomic to operate. These are both widely tracked data points. 

In truth, many advisors would probably have moved out of the fund already, due to that "poor performance" thing. However, as McCarthy pointed out: "Well-allocated, diversified portfolios are designed to keep from selling out when a particular asset class is down." Consequently, advisors are often reluctant to sell funds that play a specific role in their allocation: such as emerging market, value or commodity funds. The key, of course, is to watch out for funds that are out of step with their sector—which further illustrates the risk of including sectors covered by only one or two funds in a portfolio. 

The authors also cite the potential for broader problems at a fund's parent company to force fund closings or consolidations. Yet tracking these issues can be a bit trickier. To simplify identification of potential fund closings, Kern and McCarthy offer a somewhat surprising solution. While they emphasize that the Morningstar "five star ratings" don't have a very good track record for predicting top performing funds, their "one star rating" is " a very good indicator of which funds are going to close." 

While a stickler might wonder whether this is a chicken and egg thing—that is, that some funds might be driven to close because they got a one-star rating—that doesn't diminish the predictive nature of the low rating.  For advisors, the takeaway from The Safe Investor: Research Findings is that fund closings can hurt portfolio performance—and detecting these closings early creates yet another way they can benefit their clients.