A new study, “Closing and Cloning in Mutual Funds,” from two professors, Hsiu-Lang 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.
- 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.
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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