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Some closed funds ready to open for business again

  • Closed funds have seen outflows on par with open active funds, leading them to reopen their gates.
  • There's no proof that a closed fund somehow outperforms an open one.
  • Morningstar develops a watchlist of closed funds that could reopen soon for investors who prefer to park small amounts in active managed funds.
As passive investing becomes chic, outflows have increased from closed funds — which are now looking to open again.
Henrik Sorensen | Getty Images
As passive investing becomes chic, outflows have increased from closed funds — which are now looking to open again.

Managers of actively run funds can't seem to get a break these days, and that includes closed ones.

With the rise of passive investing, their business model and sales pitch for active management have come under seemingly constant attack. The latest domino: funds that had previously been closed to new investors. These funds — often run by prominent managers — have seen outflows on par with open active funds. It's leading them to reopen their gates once again. For some out there, this gives an opportunity to buy.

In a closed fund, the managers have decided not to accept new investors. This typically means that the popularity of a manager or a fund grew due to outstanding performance, leading investors to clamor. Once the assets under management become too large, the managers can't safely deploy it, so they close access.

"You close a fund to manage capacity," said Russel Kinnel, director of mutual fund research at Morningstar.

Since small-cap funds require less cash to invest in the names they hone in on, they're more prone to this practice. That's because it's either closing the fund, deciding to invest in larger names or make riskier selections in the companies within their small-cap investment pool.

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Once a fund closes, it will almost inevitably one day open again, since the natural life cycle of investors — such as hitting retirement age — will lead to outflows that outpace inflows. But as passive investing has become the chic tactic, outflows have increased.

In July the rate of outflows from U.S. actively managed equity funds reached $19.6 billion, up from $14.6 billion in June, according to Morningstar. And over the past year, $245 billion left active U.S. equity funds, compared to $283 billion heading into U.S. equity index funds. Closed funds aren't immune to this trend, and one reason some must seek investors again.

"It takes shorter and less painful bouts of underperformance to spur those outflows," said Kinnel.

It's not a guarantee of success

Cambridge University finance professor Raghavendra Rau, however, warns against rushing into that recently opened fund. In his research, he tracked 125 funds that closed between 1993 and 2004.

In the year prior to closing, the funds saw, on average, a hot streak of excess returns 15 percentage points higher than the mean average return. Meanwhile, the managers typically increase gross advisory fees by 0.04 percentage points, and a portion of those fees remain after reopening. Plus, 66 funds reopened within a year of closing and underperformed their benchmarks over the next year.

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"The reason they reopen is because they're not doing too well," Rau said. "If they continued to do very well, they never would have reopened."

There's also no proof that a closed fund somehow outperforms an open one. Over 10 years, large-cap open funds surpassed closed ones with a 7.1 percent annualized return compared to 6.9 percent. But there are some benefits in the small-cap sector, where closed funds have an 8.1 percent annualized return over 10 years, compared to open fund returns of 7 percent, according to data pulled by Thomson Reuters.t

Tread carefully

Joseph Heider, founder of Cirrus Wealth Management, often suggests clients have some activist investing exposure. When it comes to funds that reopen, however, he typically advises clients to go through their 401(k) plan platforms.

"We may look for those," said Heider, since they were "popular in the past, good track records and people want to invest in them."

Of course, these reopened funds are actively managed, which means higher fees, even if the fund didn't hike them prior to closing. The Investment Company Institute found that active-managed equity funds' expense ratios were 0.82 percent last year, compared to 0.09 percent for index equity funds.

Who to watch

For investors who prefer to park a small portion of their portfolio into an actively managed fund, Morningstar's Kinnel develops a watch list of closed funds that could reopen soon. He argues that one of the best times to invest in an active fund is as it's reopening for public investments once again.

"It's a bit of a contrarian move since [they] tend to underperform before they reopen," Kinnel said.

Among the funds highest on his list now, Diamond Hill Small Cap had $407 million in net outflows over the past year, which led to its assets dwindling to $1.6 billion. That's less than when the fund closed in 2015. And its 10-year annualized returns of 6.7 percent just beat its small cap value benchmark's return of 6.4 percent.

"The reason they reopen is because they're not doing too well. If they continued to do very well, they never would have reopened." -Raghavendra Rau, Cambridge University finance professor

Kinnel is also watching the Artisan International Small Cap fund, which is helmed by famed investor Mark Yockey. With just $581 million in assets, it saw $321 million flee as it has struggled over the past three years, falling an annualized 1.21 percent. But it does have a solid long-term track record of 3.5 percent annualized over 10 years, compared to 3.41 percent for the MSCI EAFE Small Cap index.

There's no rush to leap in, though, even if a manager puts out a Sale sign again, since you "generally see a fund that reopens stay open for a while," added Kinnel.

— By Ryan Derousseau, special to CBNC.com

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