Why You Should be Wary of Mutual Fund Mergers

This week's column stems for an email I got from a reader, who was concerned about how a proposed fund merger could impact him. It's a great question, and one which most investors don't spend a great deal of time thinking about. But fund mergers and liquidations are a great illustration of how investor interests and fund manager interests are often in direct conflict.

The reader is an investor in the Pioneer Small & Mid Cap Growth fund, which, pending shareholder approval, will be merged into another Pioneer fund, Oak Ridge Small Cap Growth.

Mutual fund mergers (in which the assets of one fund are rolled into another) and liquidations (in which the fund is simply shuttered, and returns investors' money) are not uncommon. According to Morningstar, some 399 mutual funds were merged or liquidated last year alone. Almost invariably, the fund that's being merged or liquidated has a record of poor performance and/or a very low asset base.
With only $62 million in assets, Pioneer Small & Mid Cap Growth fits the latter definition. Pioneer is apparently making too little money from the fund, so they would like to combine it with another larger fund that they run.

What's a bit unusual is that Pioneer Small & Mid Cap Growth's performance is quite respectable: its 4.6 percent load-adjusted annual return over the past 10 years places it well within the top quartile of its category. Likewise, the fund it will be merged into, Oak Ridge Small Cap Growth, also has a top-quartile performance record over the trailing 10 and 15 years.

So what's the problem? Well, there are a few.

First, investors in Small & Mid Cap Growth are going from a fund with an annual expense ratio of 1.25 percent (for the fund's A class shares) to a fund charging 1.4 percent in expenses, despite the fact that the acquiring fund is more than five times as large. In fact, Oak Ridge Small Cap's expense ratio is unchanged over the past 11 years, during which time its assets have increased more than 20-fold, from $15 million in 1998 to $306 million currently. Its fees in that time, then, have risen from $210,000 to $4.3 million, without the fund's shareholders getting a piece of the economies of scale that increase in size has enabled.

If the directors owned any shares of Small & Mid Cap Growth (and they do not), they might ask Pioneer management why they were being forced to pay 12 percent higher fees to move to a larger fund with similar performance. And if they owned shares of Oak Ridge Small Cap (and with the exception of one director with less than $50,000 in the fund, they do not), they might ask just how large the fund has to get before they get a break in expenses.

Second, Morningstar classifies Small & Mid Cap Growth fund as a mid-cap growth fund, while its replacement is a small-cap growth fund. Thus an investor who carefully chose this fund as part of his overall asset allocation has now had that allocation thrown out of whack.

Finally, two of the Small & Mid Cap Growth fund's share classes come with deferred sales loads, which Pioneer says will not be waived. So if you're an investor in this fund who decides that you'd rather not have the new fund forced upon you -- either because of its higher fees, its differing style, or, well, you'd just as soon choose your own investments, thank you very much -- you may to pay a sales load for the privilege of leaving, in addition to any taxes such a move will incur.

Ostensibly, mutual fund directors serve fund shareholders, negotiating on their behalf with the fund managers. They could, conceivably, seek to hire any portfolio manager in the world whom they thought would best serve the fund's investors. But mergers like this one show just how farcical that notion is.

What might a truly independent board interested in serving their shareholders tell Pioneer in this case? How about this:

"We understand that you're not earning a great deal of money from this fund, and won't argue with your decision to close it. However, we're going to conduct a wide-ranging search to find a manager willing to manage this $62 million portfolio in a manner consistent with its mandate, which is, presumably, a major reason why investors purchased it in the first place. We're also going to vigorously negotiate the lowest possible fees for the new manager's services. Lower expenses will be an important goal in this process; paying higher expenses would be a non-starter. If you would like us to consider one of the Pioneer managers in this search, we'll be happy to do so, but understand our first obligation is to the fund's shareholders, and we'd be failing our fiduciary duty to give you preferential treatment."

Instead of the conversation described above, the exchange is likely something more along these lines:

Fund manager: We've decided that we're not earning enough money on Fund A, so we're going to merge it with our Behemoth fund.

Fund directors: O.K. But are you sure that you'll be earning enough from the combined fund?

Fund manager: Are you kidding? We haven't lowered the fee rates on Behemoth fund in 15 years. Doing this will only increase our profits.

Fund directors: Done and done. What's for lunch?

Image via Flickr user TheTruthAbout... CC 2.0