Small funds that have high fees and haven’t seen new investors for years account for around a quarter of all funds sold in Europe, new research has found.

So-called ‘orphan’ or ‘zombie’ funds are those that have failed to reach scale (or previously reached scale and then saw massive outflows) and haven’t seen any significant inflows for years. They are the forgotten funds that need dusting off, and in many cases closing down.

Because they are smaller than their counterparts they tend to charge high fees, as there are no economies of scale, meaning that a small number of investors have to bear the costs of running a fund.

WHY DOES THIS SITUATION OCCUR?

There are a large number of fund launches each year – for example, in the past year 183 funds were launched – but the bulk of the flows go to a small number of funds, which means there are many that fail to get off the ground.

Data group Morningstar recently looked at the problem, to try to get a grip on how many of these funds exist. It deemed an orphan fund to be one where it has €100m in assets or less, has been running for at least five years and hasn’t seen inflows or outflows of more than €10m in each of the past five years. These are basically stagnant funds failing to attract assets and which have been running for some time.

There are 194 funds in the UK that meet this criteria, and according to Jonathan Miller, head of research at Morningstar, a large chunk of those are multi-asset funds or fund-of-funds, which are products that invest in other funds.

ARE YOU INVESTED IN AN ORPHAN FUND?

Investors don’t need to stick to Morningstar’s criteria to see if they are invested in an orphan fund, but it’s a good starting point.

Essentially you want to see whether any of your funds are tiddlers in size but have been running for a while. Many funds will be small if they’re new and still building up assets, but if it’s been running for five years or more and has failed to reach a decent size, that’s a warning sign.

Size is dependent on the sector the fund is operating in. Some funds choose to close at smaller sizes as they invest in niche areas of the market and so reach capacity sooner. For example, if you’re investing in a niche Japanese technology fund it’s likely to be smaller than a global equity fund.

A downwards trend in the asset size is an important warning sign. Another thing to consider is whether the charges are higher than the average fund. Smaller funds will typically have higher costs, as there are fewer investors to spread some of the fixed costs around, and the fund manager will still want to make a profit.

WILL A FUND CLOSE IF IT GETS TOO SMALL?

There’s no real incentive for fund managers to close zombie or orphan funds, unless they become unprofitable to run – and the high charges on the fund usually mean they pay their way.

Often the costs of shuttering the funds and the bad press coverage the firm might get, along with the admin of dealing with existing investor assets, means it’s not an option entertained by many fund managers.

Another option, and one that happens a fair amount, is that the fund is merged with another fund – and typically one that is much larger. This can work well for investors as it gives them the option to transfer to the other fund or to cash out – it also alerts them to the fact that they might be in a dud fund.

However, for smaller asset managers this isn’t likely to be an option, as they won’t have a similar fund into which they can merge the assets. It means that fund managers are unlikely to warn if you’re in one of these funds, because that would just make the problem worse and potentially lead to more outflows.

Morningstar’s Miller adds that some fund houses want to keep hold of the funds for ‘optionality’. This basically means they want to keep the funds so that their product range looks broader, but also so that if the sector comes back en-vogue they have a product already there, with a track record and at least some assets.

HELP, I HAVE ONE OF THESE FUNDS

If you’ve got one or more orphan funds in your portfolio the obvious next step is to consider switching into a larger fund, with lower costs and one that has grown in recent years. But it’s not always as simple for investors to just vote with their feet and sell the existing fund.

Some investors may have been in the fund for a long time and so have substantial capital gains on the investment. If it’s not within an ISA or pension they may want to sell in stages to make use of their capital gains tax allowance and avoid a massive tax bill. Ultimately, investors should be looking for the exit, even if they stage it over a few years.

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