Liquidation Blues: When Mutual Funds Close

Mutual fund liquidations, also referred to as "full closures," are never good news. A liquidation involves the sale of all of a fund's assets and the distribution of the proceeds to the fund shareholders. At best, it means shareholders are forced to sell at a time not of their choosing. At worst, it means shareholders suffer a loss and pay capital gains taxes too.

Liquidations often occur after a fund has dropped in value. This forces investors who bought when the fund was more expensive to sell at a loss. Worse yet, the fund may have embedded capital gains, which can have an immediate impact for investors holding the fund in a taxable account. This occurs when a fund doesn't sell a stock that has risen in value since it was purchased. For investors, this means that although the stock may have been purchased by the fund before some investors bought in, tax liability for those gains is not passed on to investors until the stock is sold and the gains are realized and paid into current shareholders' accounts. This occurs because of the "mutual" ownership aspect of mutual funds. Therefore, when the fund is liquidated, the investor not only sells the fund for less than the purchase price, but also still pays tax on capital gains that he or she did not get to benefit from. This can be particularly damaging to investors holding the fund in taxable accounts, as the taxes cannot be deferred the way they could be in a tax-deferred investment, such as a 401(k) plan.

Funds are liquidated for a variety of reasons, with poor performance ranking as one of the primary causes. Poor performance reduces asset flows, as investors choose not to buy into a fund that isn't doing well. It also brings down the mutual fund management firm's track record. If the firm has five funds and four of them are doing well, closing the poor performer gives the firm a track record based on four successful funds. Poor performance also results in bad publicity, which can lead to large redemptions. As the asset base falls, the costs of doing business increase. Funds operate on economies of scale, with bigger being better from a cost-savings perspective. As costs increase, it can become unprofitable to operate a fund. If investors are losing money, the fund is likely to stay open as long as the fund can be operated profitably, but when the fund company starts to feel the heat, the fund is terminated. After all, fund companies are in business to make a profit.

Fund terminations are common, particularly among new funds. If a fund doesn't gain popularity and grow during its first three years, it is likely to close. Several hundred funds closed nearly every year during the late 1990s and the early 2000s. Niche funds are particularly vulnerable, as they are often invested in fads, or focused on such a small aspect of an industry that there is a risk the concept will never catch on with investors. Signs that a fund is a candidate for closure include a big drop in performance that is sustained without recovery. A poor track record over several years is another warning. Because long-term poor performance simply isn't appealing to investors, heavy redemptions are another possible indicator.

If you've got the feeling that your fund is going away, what should you do? There are different strategies for different funds. If you're invested in an open-end mutual fund and the signs of the end are coming, it's time to head for the exit as fast as you can. When investors all want to sell a particular fund, the selling pressure tends to lower the fund's price. Getting out sooner rather than later can help you get a better price for your shares and salvage as much of your investment as possible. If you are invested in a closed-end fund, look at the underlying assets. If the fund is selling at a premium, sell to maximize your payout. If the fund is trading a discount, hold because you will get paid on the full value of the assets when the fund liquidates them.

Mutual fund closures are not extraordinary events. They happen all the time as part of the fund industry's natural business cycle. You can minimize your exposure to these occurrences by investing in funds with long track records of success and carefully monitoring your exposure to niche products. When a closure occurs, it's not the end of the world. Take appropriate action, learn from the experience and redeploy your assets to keep your long-term investments goals on track.