Dear Dagen: Lack of Cash Won't Starve a Closed Fund

If a fund underperforms after closing to new investment, it's probably not because it lacks 'fresh cash.'
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I have heard that many closed funds begin to perform badly because of a lack of fresh money to continue buying. I own (WEHIX) - Get Report Weitz Hickory, for example. Should I be concerned? -- Morris Pomey

Morris,

Often the problem with a closed fund is not that its doors have been shut. It's that the investors inside are already pressed together, cheek to jowl.

Firms will typically shutter a fund for one of two reasons: Either the fund has gotten too large for the manager to handle or money is pouring in at such a pace that the manager can't invest it quickly enough.

The actual closing might be evidence that a manager is having trouble investing the fund's assets.

If a fund is too big, a manager may have a difficult time trading in and out of the portfolio's positions. These problems can be particularly pronounced in small-cap funds. With stocks that are small or illiquid, it's riskier to take on large positions because they can be harder to get out of without driving the price down. Or a manager might be forced to buy stocks with larger market caps or to increase the number of securities in the portfolio, thereby changing the composition of the fund.

"There are some things I used to be able to buy that I can't anymore," says Rick Lawson, manager of the $750 million Weitz Hickory fund. Lawson's fund closed in August 1998 after its assets surged from $20 million at the beginning of 1998 to about $500 million at the time of closure.

Last year,

Charles Schwab's Center for Investment Research

evaluated the performance of 49 funds that were closed as of Dec. 31, 1997, comparing each to a benchmark index and to its peer group for maximum 24-month periods before and after closing.

The results for those funds showed an average monthly outperformance of 45 basis points over their peer groups and 39 basis points over the benchmarks before closing. After closing, that advantage was reduced to 2 basis points against peers and 4 basis points against benchmarks. In short, they wound up becoming average funds.

In the study, Schwab came up with two possible reasons for this decline. Either the funds waited too long to close, exceeding the critical size at which they were able to generate peer- and index-beating numbers. Or it's possible the outperformance before closing was the result of luck and not the manager's skill.

But a lack of cash flow is not the problem, as you suggest in your question.

In fact, many funds will close to new investors only and continue to take in additional assets from existing shareholders, 401(k) plans and investment advisers.

Schwab actually examined these continued inflows as a possible source of the mediocre performance. The study concluded that "the small amount of new cash after a fund closes should not be a burden to the portfolio manager."

Sure, a fund that is forced to sell stocks to meet redemptions could be faced with a serious performance downfall. But that's not an issue exclusive to closed funds. A fund that's still open to the public could very well experience the same problem. And if a closed fund's assets are declining rapidly, it can always reopen.

According to Schwab, the average closed fund turns into a middling performer. But some funds do seem to defy that. Look at what the gargantuan

(FMAGX) - Get Report

Fidelity Magellan has been able to do. Since it closed Sept. 30, 1997, this fund has delivered a 43.6% cumulative return through Aug. 5, compared with 42.4% for the

S&P 500

. That's pretty miraculous given that fact that Bob Stansky is waltzing with $100 billion in the fund. (Magellan is one of those closed funds that continues to accept new money from current investors and 401(k) participants.)

The Weitz Hickory fund did indeed suffer a performance downturn after it closed last year, but this year it has come back with a vengeance. In 1999, the fund is up 16%, compared with 6.5% for the

(VFINX) - Get Report

Vanguard 500 Index fund.

There's no easy way to tell which funds will do well and which ones will falter. Plus, there's no magic number that will tell you when a fund has gotten too big. Who would have believed that Magellan would be beating the S&P 500?

When investing, look for funds that have a prestated closing point. Also keep an eye on how rapidly a fund's assets are growing. If you witness a dramatic surge in cash, you should at least be on notice that performance could start to falter. And if the cash position in a fund begins to swell, that could be a sign that the manager is having difficulty putting new money to work.

Also be on the lookout for an increased number of holdings or stocks that have dramatically higher market caps than those the fund is accustomed to owning. Both might signal problems related to too much money.

If you hear about a fund that is getting ready to close, try to fight the urge to rush in. If you don't already own it, there is no evidence to suggest there's some kind of benefit in buying a fund that's closing.

However, if already own a fund that's shutting its doors, there may not be any harm in holding, at least for a while. You may want to give the manager some time to get his or her house in order before making your sell or hold decision.

Send your questions and comments, along with your full name, to

deardagen@thestreet.com.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.