What to Do When Mutual Funds Close?

Ruth Saldanha: Recently, investors in four of Ninepoint Partners' private credit funds found that their asset manager had suspended redemptions, meaning that the investors could not sell the units in those funds. In this particular case, the reason given was an increase in redemption after the collapse of Bridging Finance and the resulting tension in private debt markets. These funds were in the alternative investment space and had a risk profile ranging from medium to medium to high. Though in this case redemptions have been suspended (And Ninepoint says the funds are strong and not closing or liquidating), it is not uncommon for funds and indeed ETFs to close or liquidate, especially when the funds target very specific niches or themes. So, why does this happen, and is there any way for you to spot warning signs and perhaps avoid such funds altogether? Morningstar Canada's Director of Investment Research, Ian Tam, is with us today to discuss this. Ian, thanks so much for being here today.

Ian Tam: Always a pleasure, Ruth.

Saldanha: First up, why do funds close?

Tam: Yeah, a great question. It's important to delineate a couple of terms here. So, when a fund closes in a negative sense that I think you're referring to, it's usually referring to a liquidation or possibly a merger of the fund into another fund, and that typically happens due to performance-related issues resulting in a general lack of interest from investors, at which point it no longer makes financial sense for the fund company to continue to keep running that investment fund.

In other cases, in a more positive light, sometimes a fund can be closed but only to new investors, and that's generally a positive move for the fund and a positive for those that are already invested, because when that happens, a fund manager comes to the realization that they can no longer maintain the investment strategy or investment objective because the fund has grown too large. A very simple example of that is perhaps a small cap fund. So, once a small cap fund reaches a certain size, it becomes very difficult for the portfolio manager to enter and exit positions in small cap companies without significantly moving the market. So, that's more of a positive spin on funds closed to new investors.

Saldanha: Sticking with the negative sense right now, what should I do if I hold a fund that is going to be liquidated or that has liquidated? What does this mean for me?

Tam: Yeah, once your fund is liquidated, or if your fund announces it's going to be liquidated, generally it means that the remaining assets in that fund are going to be sold off at the market price and the principal will be returned back to you. And unfortunately, that is treated typically as a sales event. So, in the case where you hold that fund in a non-sheltered account, so a margin account as opposed to an RRSP or TFSA, that will trigger a tax event, typically, capital gains tax. And again, unfortunately, that's going to be beyond your control in the case of the liquidation.

More than likely though, the fund company that chooses to close that fund will merge the assets into either another share class or a fund with a very similar investment objective, and that's a lot more common and happens frequently when fund companies are restructuring their lineup, and when that happens, you simply hold units of a slightly different mutual fund or ETF.

Saldanha: Is there anything I can do about this if this was to happen with my investments?

Tam: Yeah, there's really not much you can do about it, because there's no way to tell in advance, of course, if the fund is going to be liquidated. But if you are able to pick a high-quality manager with a proven track record, that will greatly reduce the probability of you holding a fund that gets liquidated or merged. So, to help with that, I did run a study a couple of years ago on how effective the Morningstar Star Ratings were for funds domiciled in Canada. Just as a quick reminder, the Star Ratings, unlike our Analyst or Quantitative Ratings, are a very objective look-back at a fund's risk-adjusted returns after fees compared against the category average or compared against peers.

So, if you have a look at the chart on the screen here, you'll see that when I ran this study, roughly 59% of funds that were rated 1-Star back in 2010 ended up being liquidated or merged by 2020 or 10 years later. On the flip side of that, only 27% of 5-Star funds were then liquidated or merged. So, put in other words, over the last decade, 1-Star funds in Canada were more than twice as likely to be liquidated than 5-Star funds, and that further points to the efficacy of Morningstar Star Ratings as a starting point for further research.

Saldanha: So, what should I do to ensure that none of my funds close or none of them get liquidated?

Tam: Yeah. So, aside from considering the fund's track record, you might also look at the broad investment approach of the fund. And I think you referred to this earlier, but in recent years, we've seen a pretty large explosion of what Morningstar calls thematic funds, or those that invest in a potentially disruptive trend that spans multiple economic sectors. So, for example, automation, big data and even e-sports or e-gaming are themes that have translated into equity-focused investment products.

So, even though these funds tend to tell a pretty good story, our data shows that globally thematic funds have a much higher mortality rate than their traditional counterparts. So, on the chart on the screen, you'll see that over the last 15 years, more than half of thematic funds ended up being liquidated. And of the remainder only 22% of overall funds survived and outperformed a broad global equity index. My colleague Ben Johnson puts it very well. When you're invested in a thematic fund, you're effectively making three bets. One is that you pick the right theme, two is that you pick the right manager, and three is that that theme hasn't already been fully valued. So, the payoff for investing in a thematic fund can be very large, but the chances of that happening are slim. So, certainly, something to consider if a fund's closure is an area that you're concerned about.

Saldanha: Great, thank you so much for being here today, Ian.

Tam: Thanks, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.