You Should Evacuate Before Your Mutual Fund Liquidates

If you happen to own a struggling fund -- say, one that invests in the emerging markets -- your investment could very well go the way of the Ford Pinto.

This year, mutual-fund companies are liquidating funds at a record-setting pace. And if you happen to own a beleaguered bond or emerging-markets fund, yours could be the next to go.

Many investors, who have already had to deal with dreadful performance of a struggling fund, may be wondering whether it's worth it to look for signs of life. The answer: Things will probably get worse until the fund gets liquidated, so it's best to get out while you can.

Through August of this year, firms have liquidated 168 funds, according to Wiesenberger/Thomson Financial. That means these fund companies have permanently closed the funds and given investors their money back.

For comparison, 160 funds were liquidated during all of 1999. In 1998, a record 222 funds were liquidated, but that mark could be surpassed this year.

It stands to reason that more funds are shutting down, and not just because the market has been less than stellar this year. The number of new funds rolling out has increased exponentially in the past decade. In 1990, a year that began with 1,100 equity funds, 92 new funds were introduced. In 1999, according to the most recent figures available from the Investment Company Institute, the total number of funds stood at 3,952, up more than 400 from the previous year. As of August 2000, there were 4,215 funds. Not all of these funds are going to find an audience, especially if they are underperforming.

The victims?

Consistently poor funds with dwindling assets are the ones usually targeted for liquidation. This year portfolios that invest in bonds, real estate and the emerging markets are the ones being liquidated, says Ramy Shaalan, a mutual-fund analyst at Wiesenberger.

A fund's assets can fall dramatically due to market losses and redemptions, and a fund firm might think that it cannot attract more assets in the future -- especially if performance remains weak.

A fund might be so small and its future so bleak that it becomes too expensive to operate. (A fund needs about $50 million in assets to be profitable, says Shaalan.) A money management firm would rather focus on the funds that it can easily sell -- think tech -- than those struggling to attract any attention or money.

Look at Invesco, for example.

The Denver-based fund company wants to liquidate its (IVSLX)Latin American Growth fund and its (FPBSX)Pacific Basin fund. A shareholder vote is scheduled for November.

These areas of the market have been extremely weak and these funds haven't found a following among investors.

The firm's Latin American fund has a three-year average annual return of minus 14.3%, trailing 90% of peers, according to Morningstar. The fund had only $26 million in assets at last count.

The Pacific Basin fund is just as bad. With its three-year annualized return of minus 10.3%, the fund also trails 90% of other funds in its category and commands just $68 million.

Although you might be loyal to a struggling fund, these liquidations are often in the best interest of shareholders. With a small or shrinking fund, shareholders are probably paying way too much in expenses.

"What is usually happening is the adviser is capping or reimbursing the expenses," says Pamela Wilson, an attorney with the law firm of Hale and Dorr in Boston. "Both shareholders and the adviser are suffering terribly."

If you get stuck in a rapidly shrinking fund, you bear more of the expenses as more shareholders leave, and you could also get hit with a huge capital-gains distribution. A manager is forced to sell more and more securities to come up with cash to meet redemptions, possibly realizing taxable gains that will eventually be passed on to the remaining shareholders. Needless to say, you don't want to be the shareholder who's left to turn out the lights.

In some cases, it's better to force the shareholders out of a fund with a liquidation. The remaining shareholders leave together in a more fair, orderly fashion, says Wilson.

The decision to liquidate is often in the hands of a fund's board of directors and doesn't require a vote by the shareholders. (It depends on a fund's organizational documents under state law.) But this is not a decision that a fund's board should take lightly.

A liquidation is a forced taxable transaction. In effect, shareholders are being told when to sell their shares. If a fund that's poised for liquidation has produced dreadful returns over the past few years, shareholders are probably sitting on losses, which would not be taxable. As an upside, those losses can be used to offset gains generated through other trades. But gains realized in a liquidation would be taxable.

To avoid a taxable liquidation, a fund company might try to merge one struggling fund into a similar fund that's still viable. Fund mergers aren't taxable transactions. But if a natural match doesn't exist, you could wind up saying goodbye to your fund.

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