Investors preparing for college costs and retirement have long been told to pick a good set of funds, add money regularly and stick with it for the long term. But sometimes they’re thrown a curve, when the fund company closes a fund to new investors or, even worse, shuts it down altogether.
This happened Jan. 3, when fund giant Vanguard Group announced it would shut down the Vanguard Convertible Securities Fund (ticker: VCVSX). The fund, launched in 1986, had $962.5 million in assets at the time and was closed to new investors ahead of a complete liquidation planned for March. It specializes in convertible bonds — bonds that can be traded in for stock — an asset that mainly appeals to fixed-income investors.
“Shareholders of the fund are being notified and have the opportunity to exchange into another Vanguard fund or redeem shares prior to the liquidation date, at which time the fund’s assets will be sold and the proceeds distributed,” Vanguard said.
In other words, investors who don’t switch to another fund or redeem will get cash, as if they’d withdrawn everything.
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“You don’t have to go home, but you can’t stay here,” says Nicholas Juhle, vice president and director of research at Greenleaf Trust in Kalamazoo, Michigan. “When a fund shuts down, it is kind of like when a store you have consistently patronized goes out of business — you won’t be able to shop there anymore. In the case of a fund shutting down, it will no longer manage your assets and will be returning what you have claim to.”
Obviously, that will be disruptive to investors who had planned to stick with the fund for the long term. They can opt to buy a similar fund and things might turn out just fine. But fund shutdowns don’t always come at a convenient time for choosing an alternative in a portfolio. Prices may be high or the market too volatile.
Also, the cash distributed to investors can trigger a tax bill, just as if the investor using a taxable account had sold shares at a profit. Sometimes fund firms avoid a tax event for investors by rolling the assets of one fund into another.
Fund shutdowns are hardly epidemic but do occur often enough that investors should be aware of the possibility. In 2017, the latest year for which figures are available, 383 funds were liquidated in an industry with nearly 8,000 funds, according to the Investment Company Institute.
Typically, a fund is shut down because it hasn’t drawn enough investors.
“Despite the fund’s capable advisor and prudent approach to managing convertible securities, the fund has not gained broad acceptance among these investors and remains one of the smallest offerings in terms of net assets among Vanguard’s stock and balanced offerings,” Vanguard says in a statement announcing the closure.
In fact, the fund had performed fairly well, returning an average of 9.43 percent a year for the decade ended Jan. 30, according to Morningstar.
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Chris Tuck, wealth advisor at SJK Wealth Management in Doylestown, Pennsylvania, says funds are also shut down because the parent company finds they do not have enough investors to justify the cost of servicing the investments.
“Often, we see ‘soft’ closes, meaning that the fund is closing to new investors but remains open to existing shareholders,” he says. “This happens a lot in the small and mid-cap spaces.”
This is not harmful if existing investors can continue adding money.
A fund may also close to new investors, or liquidate, because it has become so successful it cannot continue to buy hard-to-find assets in its preferred sector, says Scott W. Cody, partner at Denver-based Latitude Financial Group.
“The flow of new assets into the fund can be so great that the fund needs to be closed because it will be difficult to find enough good companies to buy without moving a market,” he says, citing small-cap funds.
While fund liquidations can come out of the blue, experts say investors are wise to avoid funds with red flags, which may be telegraphed in fund statements and management discussions. A big fund that specializes in obscure holdings could run into trouble, for instance, as could a small fund that is losing more investors than it is adding.
Poor performance is worth pondering even if you think a potential turnaround is likely. Turmoil like frequent manager changes is another bad sign. In all cases it makes sense to see how competing investment funds are faring.
Tuck says before investing in any fund, look for the potential capital gains exposure. That tells the portion of the share price attributable to realized capital gains as the managers sell holdings at a profit. In a liquidation, these embedded profits can trigger tax bills for investors using taxable accounts.
Juhle says investors can avoid this bill by selling the shares before the liquidation takes place. That way the tax would be on the difference between the sale price and original purchase price.
Tuck also notes that specialty funds like Vanguard’s are falling out of fashion as investors move to generic products like index and target-date funds, putting specialty funds in liquidation danger.
Tenpao Lee, economics professor, at Niagara University in Niagara Falls, New York, says investors can minimize liquidation risk by sticking with large, popular funds.
“Unless you are a professional, invest your money to index funds or funds with (a strong) historical record,” he says.
An investor who has experienced a liquidation must, of course, decide how to reinvest the cash. If the portfolio has been carefully allocated, the obvious choice is a similar fund, though the influx of cash could also be an opportunity to try something new.
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Either way, Tuck recommends proceeding with caution by reinvesting over time through dollar-cost averaging.
“If an investor decides they want to stay in this space, a dollar-cost averaging is prudent if allocating into a similar fund,” he says. “However, going from fully invested in that space to completely out is not great. An accelerated dollar-cost averaging in might be worth considering.”
That would mean making the new investment over several months, to reduce the risk of buying at a high price all at once.
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What to Do When an Investment Fund Closes originally appeared on usnews.com
