Watch Out for Funds In a 'Death Spiral'

If you're invested in funds experiencing a "death spiral," that could mean the death of your assets, too. Here's what to watch for, and how to avoid this problem.

The downward spiral occurs when a fund with subpar performance suffers redemptions, which compounds the loss in assets from its negative returns. Chronic losses of assets diminish its size to the point where its fixed costs balloon as a percentage of net assets. At that point, a high level of expenses must be overcome before positive returns to shareholders can be achieved. The elevated expenses result in additional disappointing returns that lead to more redemptions and diminished assets; a vicious, self-perpetuating downward cycle is established.

Open-end mutual funds have fixed expenses for legal and compliance expenses, preparation and submissions of regulatory filings and production of shareholder reports, not to mention fees for transfer agents and custodial services. At a minimum, they run tens of thousands of dollars annually, which doesn't amount to a significant percentage of assets when a fund is worth $100 million or more. But the expenses are still there when the asset base gets driven down to just a few million or less.

A classic example of the self-sustaining downward spiral is the American Heritage Fund(AHERX Quote). Devastating losses resulted in redemptions by investors that combined to drive its total net assets down from $150 million in 1993 to its current size of less than a third of a million dollars.

So, investors in The American Heritage Fund are now saddled with an expense ratio of 14.15%, meaning the fund must appreciate by that percentage before its net asset value per share shows any gain at all. (Typically, funds in such "expense trap" conditions will forego some management fees and boost shareholder returns by assessing only reduced "net" expense ratios.)