‘Hidden’ funds distort performance

Investors are being warned that the under performance of funds is being “hidden” when they are merged with other investments – which is skewing fund return data and making it hard to compare investments.

Fund managers are increasingly merging their less successful funds with larger or better performing peers. More funds were swallowed up last year than at any time since 2004, with 68 mergers in total, according to Lipper.

Most of the main fund management houses – including Henderson, Aberdeen, Gartmore, Schroders, Fidelity and Invesco Perpetual – have merged at least one of their funds in the past 18 months. So far this year, 22 funds have been merged while 61 have been liquidated.

Fund managers often opt to combine funds when a less popular fund shrinks in size to the point where it is no longer cost-effective. But this can skew performance figures as the fund disappears when it is merged into a larger fund.

There have been nearly as many funds closed or merged with other funds in the past decade as there have been new launches, according to TCF Investment, the low-cost fund manager. It said that 2,507 funds had been launched in the past 11 years, while 2,400 were closed or merged.

A bad year in the market often prompts funds to merge or close as they shrink in size. Last year saw the highest number of fund closures since 2005.

David Norman, co-founder of TCF Investment, warned that mergers made it hard for investors to get a true picture of fund performance in a sector. “It makes a huge difference to the track record as all the bad ones are really bad.”

Fund managers often quote their performance relative to other funds in the sector, with “top quartile” funds trumpeted by marketing departments. However, Norman said investors would be better off checking the performance of their fund relative to its index.

Nick Sketch, a private
client wealth manager at Rensburg Sheppards, said that fund mergers can also affect the performance of the larger fund, as the new fund manager is stuck with small, underperforming stocks in the portfolio that are difficult to sell.

He said investors should beware of mergers into “best ideas” funds – those that are supposed to have only a selection of hand-picked stocks – or small
cap funds that work best when their size is manageable. An inflow of new holdings from another fund could distort the investment philosophy of such funds, he said.

Closures or mergers can offer opportunities, though. Advisers said investors should keep an eye out for closures in certain sectors, when fund managers are unable to market the fund if the sector is out of favour. This can present a buying opportunity.

“When people start closing funds, that tends to be a good sign that the market is oversold and no one wants it,” said Mark Dampier, head of research at Hargreaves Lansdown.

The emerging market sector saw a number of funds close in the late 1990s, while tech funds closed down after the tech boom in 2001. But remaining funds in both sectors subsequently did well.

Blackrock recently decided to close a fund investing in Japan, a country that has yielded flat returns for years, which Dampier argued could be a sign to start investing in the country.

Sketch said that small cap and property sectors, where funds are currently shutting down, could also yield opportunities. However, he warned that buying funds in a “zombie state” that are trying to sell off their holdings could be a risk for investors, as fund managers can be forced to sell at a discount.