Although containing general information about fund investing, this post likely will be of particular interest to members following SMI's Sector Rotation strategy.
Mutual funds that are posting great performance numbers sometimes close to new investors. We've seen that happen more than a few times with funds picked as SMI Upgrading recommendations.
Why would a fund manager put up a "Sorry, We're Closed" sign? For reasons both practical and legal.
Morningstar explains the practical side:
[A fund may close to protect current] investors. If a fund's asset base gets too large to effectively execute its investing style, it could cause the managers to stray from their process.
This concern is common for smaller-cap funds, especially when small-cap stocks are on a roll. As the small-cap fund’s assets grow, it’s harder to build meaningful positions in tiny businesses because larger trades are more likely to have an impact on the underlying stocks' prices....
And changing the process to accommodate more money — for instance, moving toward more-liquid investments or running the fund in a less concentrated style — increases the probability that the fund will behave differently going forward, dulling its merit for shareholders.
At Seeking Alpha, writer Dean Young explains it this way:
Most active funds that perform well over a short period of time get significant inflows. Soon, the fund becomes too large to easily replicate the previous performance, especially if the fund is invested in small cap stocks. Investors sell out after poor performance, causing the underlying holdings to fall, causing more sell outs.
For the legal aspect, here's a snippet from 20somethingfinance:
According to the Investment Company Act of 1940, diversified mutual funds are only allowed to buy into positions of companies that equal at most 5% of the value of the fund (you will notice that in holding disclosures that some stocks may be over 5% of a fund's holdings, but this is due to capital gains, not buying a larger position).
This law, combined with bloated assets in a fund usually results in the fund being forced to buy into more and more companies.... It becomes increasingly harder for that fund to outperform. It loses its competitive edge.
In some cases, a fund may close to new investors for only a few months. In other cases, new investors are kept out for many years. Example: A mid-cap fund run by T. Rowe Price reopened in 2020 after being closed to new investors for more than a decade!
Unlike traditional funds, ETFs can't close
Having too much money to manage has never been an issue for exchange-traded funds (ETFs) — until now. Few ETFs were actively managed, and those that were didn't attract much money. Things have changed, as the nearby graph shows.
But unlike traditional funds, ETFs — which have a different structure than traditional funds — can't close to new investors. Even in the face of massive inflows, a fund manager can't hang up a sign that says, "Sorry, We're Closed."
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