Why is it so difficult to close zombie funds?

While UK funds continue to multiply and post-RDR fund flows concentrate further, are a long, thin tail of zombie funds approaching their doom?

Increasing layers of regulation have meant the costs of closing a fund have risen since the RDR was introduced, which has meant many fund management groups have found it more cost-effective to keep small funds open than shut them down.

In addition, unless it is absolutely necessary, some fund management groups can be reluctant to close funds for fear of the public admission of failure or mistake. However, Artemis head of product and distribution development Alan Gadd says the increasing concentration of asset flows into fewer funds is making some smaller, underperforming funds increasingly hard to justify.

He says a fund hovering around £20m to £30m can usually carry its costs and some managers may feel it better to let it tick over rather than close up shop.

“It may be cheaper to run it rather than going through the rigmarole of paperwork and getting in touch with investors – and the reputational impact as well,” he explains.

However, he thinks the effects of the RDR are likely to push a change for the better as advisers and investors review their funds and move toward the more popular few.

“In the past there has been a high level of inertia. Some funds will start to effectively wither on the vine and then people will have to take action because they will start to really underperform,” Gadd explains.

Mergers are usually a popular way of trimming fund ranges because there is more chance of retaining management of the asset within it, he says. “If you are writing with a merger proposal, you will lose some of your assets,” he explains. “But if you are writing to people telling them you are closing the fund, you could lose a lot of the assets.”

In 2009, during the aftermath of the global financial crisis, 229 funds were shut down and five merged away. Over the following four years, 367 have been closed up and almost 200 combined with others. But the number of funds continues to rise, from 2,366 in 2008 to 2,493 by 2012, according to IMA figures.

F&C Investments multi-manager co-head Rob Burdett says there appears to have been more mergers and closures this year owing to the high number of consolidating firms. “That will almost certainly mean 2014 will be one where more funds close.”

He says the underperformance of the average manager could be down to a “negative survivorship bias” from the languishing funds that should have been closed.

“You have got funds that really should have been taken outside and shot and that just does not happen.”

Difficult to manage

“It’s a difficult area for companies to manage well but I do think there are a good number of orphaned funds that we thought would be swept up but that is just not the case,”
Burdett says.

The fact that “in all areas of our industry the regulatory burden is going up” may explain why some asset houses find it more cost-effective to allow a fund to drift on rather than shut it down, he says.

Indeed, Henderson Global Investors head of product James Bowers believes it is harder to merge two funds than it is to shut one down.

“The backdrop to all this is you have got to keep the investors’ best interests in mind: customer interest before commercial interest. And that has certainly driven far more behaviour and activity than it used to.”

Closing a fund cannot be done on a whim, he says, with sub-economic size one of the only ways to justify a closure.

It takes about three to four months between deciding on closure and working through the investor and regulator approval.

“It is not just more difficult to execute a merger, it is also more costly. A huge amount of investor consent is required,” Bowers says.

Both funds’ investors need to approve a merger, whereas in the past only investors in the collective being merged away needed canvassing, he adds.

“From a corporate perspective, it is always difficult to demonstrate the cost-effectiveness of large merger programmes,” he adds.

There are always “too many funds”, he says.

“There is a longer and longer tail of funds where it is difficult to see what purpose they are serving,” he says. 

“But it has certainly become more difficult to do something about it from a company perspective.”

Henderson went through a significant period of rationalisation with acquisitions of stricken firms New Star Asset Management and Gartmore in 2009 and 2011.

Bowers says he is happy the “heavy lifting” has been completed as the task would be much harder if embarked on today. The company’s average UK fund size is between £300m and £400m, “much healthier” than it was five years ago.

“You cannot have a situation where you are running too many small funds because the economics just does not work for very long.”

And the poor economics is shared by both the fund group and the investors, he adds.

Axa Investment Managers head of UK sales Rob Bailey says the cost of rationalising funds is “tertiary”: a cost that must be paid if the fund is no longer viable.

“The key consideration is whether the size of the fund is impacting the job it’s doing for the end customer,” he says. “If it is affecting results for the customer, then it does not matter how many how many hoops you have to jump through, it’s the right thing to do [to close or merge it].”

AXA IM last month announced it would shut down its £7.2m Sterling Gilt fund in September because yields have fallen so low it can no longer cover costs.

Meanwhile, another bond fund, the £4m Sterling Long Bond, will remain running because a major holder of the fund is happy with its performance, he says.

Sometimes it is worthwhile retaining a fund that is temporarily out of favour, if it is likely to be in demand soon, he adds. But that is a much more subjective task.

“The last thing you want to do is shut a fund and then, six months later, everyone wants to invest in it.”

Aviva Investors UK financial institutions sales director Jeremy Leadsom says regulation has had a great effect on the proliferation of funds. There are 2,328 funds in the IMA directory, much more than in the early 1990s, when there was about 1,500, he says.

“Over the years, the regulations have changed and that has allowed fund managers to run funds they couldn’t before.”

That includes retail absolute return funds and open-ended direct property offerings, which were not allowed in the 1980s.

“Regulations have moved on and given investors more choice,” Leadsom says.

“But it also means fund managers have more responsibility, and need to keep their fund range at a size you can effectively manage.”

The ability for funds to sprout is important for the industry’s innovation, he says.

A desire to merge

“Everywhere you look most firms have launched multi-asset funds and in five years’ time some will be well supported and others will not, and there will be a desire to merge,” Leadsom says.

Although, the number of truly retail-facing funds may be smaller once old funds that hold either internal money or cash from historic disintermediated sales are stripped, he adds.

Those funds are usually no longer marketed to the public, and are likely to fade away once unitholders retire and redeem, he says. Another thing that could cause a drop in the number of funds is an equity market correction.

“If market conditions were such that people didn’t want to invest in equities and the funds were not making money, the number of funds may drop,” he says.

According to IMA figures, there are 1,352 equity funds in the IMA compared with 347 fixed income. Mixed asset makes up 425.