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The Dark Side Of the Urge to Merge Funds
By Ali Jaffery

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The mutual fund world seems poised to shrink, but that might be a more pleasant and profitable experience for fund companies than for the fund investors.
Investors' low morale and with the S&P 500 underwater over the past three years, it is a recipe for a continuing wave of mergers within fund families and among asset managers.
Fund mergers are often presented as a win-win proposition. For fund managers they erase poor performers without diminishing a manager’s assets or sapping its fee income. And for shareholders of small, battered funds they land them in supposedly better options.
But holders of large funds have reason to be wary if their funds' become a graveyard for small stragglers. These acquiring funds often see returns buckle under the weight of the inherited stocks and shareholders.
When two funds merge, the target or vanishing fund's holdings are added to the acquiring fund's portfolio. Shareholders of the vanishing fund end up with an equal investment in the acquiring fund.
On balance, the marriages are positive for shareholders of target funds who usually see their returns rise and their expenses drop. But shareholders of the acquiring fund -- often a larger group -- don't do so well.
The vanishing funds' shareholders see better post-merger returns because they're invested in a portfolio that has performed better and also has lower expenses. Since the acquiring fund is usually larger, it's fees tend to be lower, taking less of a bite out of returns.

While mergers can give a fund company a relatively painless way to sweep sagging funds under the carpet, they can make it tough for fund investors to measure a firm or fund's quality. In the somewhat rare instances where a larger, mediocre fund merges into a smaller fund with a better record, you're left with a large fund whose record was built with a much smaller asset base.
The merger trend should continue as fund companies look to rationalize the glut of stock funds rolled out in the 1990s. Ten years ago there were about 880 US stock funds and since then their ranks have nearly quadrupled. Industry vets say most stock funds need between $50 million and $80 million to cover their costs. Today more than 1,000 US stock funds have less than $50 million in their coffers and stocks' anemic returns leave many of these minnows with little hope of gathering assets any time soon. The bleak situation could also trigger more mergers among asset managers.
The bottom line is that fund mergers can pretty up a manager’s lineup but for the investor they should raise a red flag.

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