Fund capacity issues not always obvious - Eric Uhlfelder

European fund managers are only beginning to concern themselves with investment capacity issues and the need to shut their doors to new investors. But in the US, closing a fund is not all that an uncommon occurrence.

To date, T Rowe Price has closed $36.7bn (€27.4bn, £18.5bn) worth of funds, Vanguard $86.2bn, and Fidelity over $268.4bn. These are startling numbers, especially when one considers that they represent 8.7 per cent of Vanguard's assets, 18.9 per cent of T Rowe Price's assets, and nearly 30 per cent of Fidelity's assets - all net of money market funds.

But the phenomenon is not limited to big fund families with assets spilling over their portfolios.

In May 2005, with total assets of just $7.36bn, the well-respected value investor Tweedy, Browne in New York closed both of its funds - the Global and American Value Funds.

Christopher Browne, one of the company's fund managers, had said at the time that the "current stock market levels worldwide present few investment opportunities selling at an attractive discount to intrinsic value. Moreover, certain holdings have risen to levels of full value in our view, resulting in both funds being net sellers of securities".

The lack of investment opportunities is probably a minor matter aggravated by more challenging issues. According to Spence Fitzgibbons, vice-president of product management at the Kansas City-based American Century Investments with more than $100bn of assets, the flow of so-called hot money into funds that have been doing particularly well can play havoc with efficient fund management.

In just two years ending in 1999, American's International Discovery Fund saw assets soar from $622m to nearly $2bn on the back of strong performance, which culminated in an 88.5 per cent gain in 1999. So the company decided to soft close the small- and mid-cap international growth fund in January 2000. This shuts off the fund to new investors but allows existing investors to add to their holdings.

Some of the metrics employed by American Century to determine when capacity is being approached include a limit of 5 per cent of the portfolio for individual holdings and a limit of one third of a stock's average trading volume for individual postions.

When the latter occurs, liquidity can become a factor, especially as a manager attempts to exit a position. Excess assets can also make it difficult to establish meaningful positions in small up-and-coming stocks.

Mr Fitzgibbons is also mindful that when a fund's capacity is reached, managers may see cash pile up or establish positions in so-called "secondary" choices, which can lead to over-diversification.

"These actions may be adverse to shareholder interests by compromising both a fund's strategy and overall performance," he notes.

After American Century closed the International Discovery Fund in 2000, it ended the year down by more than 14 per cent, basically matching the MSCI EAFE (Europe, Australasia and Far East) Index. Yet, assets declined by one quarter as the flow of hot money stopped and investors started pulling out of foreign markets.

"This didn't bother us though," Mr Fitzgibbons says, "because we felt more comfortable managing a smaller asset base." The fund's relative performance bore out the merits of doing so. Between 2000 and the end of 2006, it made annualised returns of 11.14 per cent, topping EAFE by a yearly average of 5.5 per cent. Despite assets having remained fairly stable, currently at $1.6bn, the fund never reopened.

While fund companies close a successful fund to help ensure continued performance, some are occasionally reopened. T Rowe Price's New Horizons Fund, whose inception dates back to 1960, has closed and reopened several times. After having shunned new investors for six years, it reopened in May 2002 to counter the effects of negative cash flows.

Then there are funds that close but virtually clone themselves for new investors. In May 2005, Julius Baer closed its top-performing International Equity Fund, which had grown from $600m as of the end of 2001 to more than $12bn in assets on annualised returns of 15.06 per cent. The fund outperformed EAFE by 4.85 per cent and nearly doubled the performance of its peer group.

But on the day it closed, it opened the International Equity II Fund, run by the same managers following pretty much the same investment strategy. The main difference: the new fund could not invest in companies with market caps of less than $2.5bn.

On the surface, it certainly wasn't obvious how starting a second version of the fund was in the best interests of existing investors.

But so far, the new version - having appreciated 28.6 per cent in 2006 and 3.71 per cent during the first 11 weeks of this year - has kept close pace with its brethren. And it has done so without having been a drag on the original fund, which turned in even better results, gaining 31.8 per cent and 4.55 per cent over the same periods.

But stopping the flow of new investor assets into a fund hardly assures future returns, especially if a fund is already struggling.

Fidelity closed its Magellan Fund in September 1997 with $61bn in assets, in attempts to stabilise performance, which many observers believed had been compromised by its sheer size. But Fidelity's former flagship fund continued to stumble. Its 10-year annualised returns were just 6.8 per cent, 83 basis points less than the S&P 500, and its assets have declined to $43.81bn.

While constraining rapid asset growth sounds intuitively helpful, it's not clear whether closing a fund is superior to alternative strategies, such as diminishing back-end loads. This would attract and reward committed investors and sales intermediaries, while preventing asset base attrition.

Moreover, the main argument for closing a fund - limited investment capacity - may not be a transparent issue. A number of fund companies run proprietary accounts that shadow their public funds. This could arguably stress a fund's capacity well before it would become public knowledge.

Since its inception in 2001, the US-focused Allianz NFJ Dividend Value Fund has generated five-year annualised returns of 12.42 per cent. That is nearly 6 per cent better than the S&P 500. With only $6.4bn in assets, it seems strange that management has decided to close this mega-cap fund in April. One explanation: NFJ has more than $20bn in managed accounts that track the fund.