Funds lying dormant with tiny assets are a disservice to investors. The extent to which these “orphaned funds” are prevalent in Europe comes to the fore in our new research paper. Also dubbed “zombie funds,” Morningstar has run the numbers on funds with a five-year track record, assets under €100 million, plus little-to-no-flows in five consecutive calendar years. The results show that far more needs to be done to weed out these substandard offerings, which are usually saddled with high fees.
Taking mainstream asset classes and removing funds from Morningstar Categories that come under the heading of “other,” we found over 15,000 funds with five-year track records. Breaking that down further shows how we reached our findings that identified 3,751 orphaned funds.
The sheer number of these funds shows the industry has launched far too many funds that are unwanted by investors. And though the total level of assets in these offerings is small, analysis in this paper shows that investors who have put money in them are often being disadvantaged. Further, if the fund companies aren't recouping the costs of running orphaned funds, then their continuing presence is effectively being subsidised by fees on the remaining funds, suggesting that even investors in perfectly good funds could have lower fees if firms were more disciplined in closing tiny funds.
As a way of examining characteristics of orphaned funds, we opted to use the Morningstar Quantitative Rating for funds. The quantitative rating extends the work of Morningstar's global team of qualitative fund analysts by using machine learning to understand the analysts' decision processes and apply them to funds that the qualitative analysts don't cover directly. It therefore allows Morningstar to provide investors with a view on our five qualitative pillars (People, Process, Parent, Performance, and Price) as well as an overall rating of Gold, Silver, Bronze, Neutral, or Negative for funds not under analyst coverage.
Allocation Funds Have the Most Orphaned Funds
By breaking orphaned funds out into their asset classes and ratings, it allowed for deeper examination, findings of which include:
Allocation funds have the most orphaned funds of any asset class. Negative-rated orphaned funds in the allocation asset class carry a median fee of 2.19%.
Of the Negative-rated orphaned funds at the end of 2017, 54.3% were in the fourth quartile in their Morningstar Category based on their five-year returns from December 31 2007 to December 31 2012 – bad performance persisted.
The median fee for an orphaned Gold equity fund is 1.14%, half that of a Negative-rated fund.
There has been a long-held view that the amount of funds available to European investors is far too large. However, we have seen little evidence of that changing. By moving the debate on to orphaned funds, the magnitude of the issue goes even deeper.
Client suitability is a key part of MiFID II, and the analysis we have provided gives little comfort on the extent to which this is in play across the board. There could be valid reasons why assets remain in orphaned funds, such as a tax impact or lack of paperwork from deceased relatives, but overall it's evident that investor outcomes are being affected, and this is an issue that should get the wider attention it deserves.
