Closing Time? The Signaling Content of Mutual Fund Closures

We analyze why managers of open-ended mutual funds choose to close their funds to new investment. Borrowing from Berk and Green (2004), we develop a model of the mutual fund closure decision where the main ingredient is a negative relationship between fund size and the fund’s realized return. We show that funds will find it optimal to restrict inflows following a period of superior performance. Because there is uncertainty regarding managerial skill, following closure, there is a net outflow of money that reduces the fund’s size and allows more skilled managers to realize higher returns. Therefore funds reopen after reductions in TNA, which allow them to maintain their pre-closing performance. Moreover, we show that the length of the fund closure period is positively related to post-reopening net inflows. We test the empirical predictions of the model on a sample of 141 equity mutual funds that closed to new investment between 1992 and 2002. Consistent with the model, closing funds outperform matching funds in the year prior to the closing, both in terms of inflows and returns. Closing also enables funds to retain their superior performance in the year following closure. Finally, we find that excess fund flows at reopening are significantly related to the length of the fund closure period.