How to tell if your mutual fund is dying

As many investors pull money from actively managed stock mutual funds, shareholders who stay put may face special risks.

For one, funds must have cash ready to pay investors who are bailing out. That may force a fund manager to sell securities in the portfolio — including stocks that the manager believes have great long-term potential.

Securities sales also may mean a fund will rack up capital gains. By law, fund taxable gains must be “passed through” to shareholders. So those who own a fund outside tax-sheltered accounts may find themselves saddled with a hefty tax bill that they hadn’t expected.

What’s more, managers of funds that are hit with heavy and sustained redemptions by shareholders can become hamstrung: Even if they find what they believe are good stocks to buy, they may lack free cash to deploy in new ideas.

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Fund management fees also may become a bigger drag on performance as a portfolio shrinks because smaller funds typically cost more to manage (as a percentage of assets) than larger funds.

Historically, mutual fund companies have rarely liquidated troubled funds. Most of the time the parent company seeks to merge such funds into other funds that may or may not have the same investment objective as the dying fund.

A Vanguard Group study of funds that were either liquidated or merged from 1997 through 2011 found that, in the 18 months before their demise, dying stock funds performed significantly worse than the typical fund in their investment category.

And while shareholders may prefer merger to liquidation, Vanguard found that merged funds’ performance after joining together still lagged their benchmark index, on average.

The upshot, fund experts say, is that investors in actively managed funds should pay attention not just to performance but also to whether their fund is shrinking — and whether that’s becoming a problem.

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