A growing number of mutual funds are merging as financial-services companies come under pressure to cut costs, but fund investors don't always come out winners.

Last year, 222 mutual funds were absorbed into other funds, a 66 percent jump from a year earlier, and the highest number since 2001, when fund companies eliminated more than 530 funds through mergers in the wake of the dot-com crash, according to investment-research firm Morningstar Inc. The trend is expected to continue as major Wall Street firms increasingly exit the competitive mutual-fund business, including last month's agreement by Merrill Lynch & Co. to sell its investment-management business to money manager BlackRock Inc. Independent fund companies also are consolidating more funds as they grapple with stiffer regulations and growing competition from other investment products.

Fund companies say mergers create economies of scale and allow them to trim certain overhead costs such as paying for audits and mailing prospectuses. Last year, Bank of America Corp.'s Columbia Management unit combined its Tax Managed Growth Fund I, which had an expense ratio of 1.31 percent, with its Tax Managed Growth Fund II, with expenses of 1.49 percent, to create a combined fund with a lower expense ratio of 1.22 percent.

There is another motivation for the mergers. Some mergers eliminate laggard funds, allowing a fund family to put a better face on its overall performance. RiverSource Investments, a unit of Ameriprise Financial Inc., plans to merge its $8.2 billion New Dimensions fund, whose returns fell near the bottom of its large-growth category over the past one and three years, into its $1.4 billion Large Cap Equity fund. The latter fund also has a poor three-year record, but ranked in the top half of its category over the past year, according to Morningstar. An Ameriprise spokesman says the combined fund will be managed using the strategy of the more successful Large Cap Equity fund.

While fund companies often benefit from combining funds, investors need to be wary. Fund mergers can depress the performance of an acquiring fund, while bestowing most of the merger's benefits, including lower fees and better returns, on the acquired fund's shareholders. Mergers that join funds with dissimilar strategies also can hit investors with higher taxes, and throw off shareholders' investment objectives.

When funds merge, "some red flags should go up immediately," says Phil Edwards, managing director of investment services at Standard & Poor's.

Mergers often need approval from shareholders, who have generally been willing to go along with the moves. But only shareholders of a fund being acquired get to vote on a deal, not the holders of an acquiring fund. There are no hard and fast rules that determine which fund is to be the acquiring fund in a merger, says a Securities and Exchange Commission official. The SEC has oversight powers to intercede in a merger.

Mergers also must be approved by the funds' boards. The Independent Directors Council, an arm of the mutual-fund trade group Investment Company Institute, is expected to deliver recommendations this spring on what issues directors should consider, including fund fees and performance, in approving mergers.

In a move that will bring higher expenses, TIAA-CREF plans to merge five stock mutual funds for individual investors into several of its institutional funds, which recently won shareholder approval for fee increases. The company will make available a special class of shares in its institutional funds for the individual investors. A TIAA-CREF spokeswoman says the company's funds "had been priced too low and had been losing money."

Some companies are combining funds that have substantially different objectives and strategies. Columbia Management last fall merged its $320 million Newport Tiger fund, an Asian stock fund, into its $1.8 billion Columbia International Stock fund, a general foreign-stock fund. "We felt that the shareholders in Newport Tiger would continue to have exposure to international investing and at the same time would benefit from investing in a fund with dramatically lower expenses," a Columbia spokesman says. The combined fund has an expense ratio of 1.18 percent, significantly lower than either of the funds before they were merged.

AIM Investments is seeking shareholder approval to merge its Aggressive Growth fund, which invests in small and midsize companies, into its Constellation fund, which focuses on mid- and large-cap stocks. A company spokesman declined to comment because voting is still under way. In a proxy statement, AIM said, "Aggressive Growth fund shareholders may lose most of their current small-cap exposure" but said shareholders would benefit from "the best available opportunities for investment management, growth prospects and potential economies of scale."

Mergers can also bring increased risks. John Hancock Funds, owned by Manulife Financial Corp., is seeking shareholder approval to merge its Small Cap Growth fund into its Small Cap Equity fund, which can buy junk bonds and do short selling, which involves selling borrowed shares in order to profit from an expected price decline. Such exotic strategies are off limits to the Small Cap Growth fund. A John Hancock spokeswoman declined to comment on the merger because it hasn't yet been approved by shareholders. In a letter to shareholders, the company said investors would benefit from "a larger combined fund that may be better positioned in the market to increase asset size and achieve economies of scale."

When two funds merge, the only performance record that survives is that of the fund considered to be the acquirer. That means fund companies can effectively erase poorly performing funds. In a study of actively managed domestic stock funds, Standard & Poor's found that fund companies were four times as likely to merge funds that had three-year returns in the bottom quartile as they were to merge funds in the top quartile.

For investors, a merger's value often depends on which of the merging funds they hold. Researchers at Drexel University in Philadelphia and the Georgia Institute of Technology found in a 2002 study of mutual-fund mergers that a combined fund typically performs better than the acquired fund in the year after a merger, but worse than the acquiring fund. For shareholders of an acquiring fund, "it's hard to imagine what the benefits are" says Edward Nelling, an associate professor of finance at Drexel and co-author of the study.

Taxes are another key consideration, particularly in a merger of two dissimilar funds. When Sentinel Group Funds proposed merging its Bond fund into its Government Securities fund in July, the company said the Bond fund would have to sell holdings that weren't U.S. government or money-market securities. Sentinel warned shareholders that these sales could result in capital gains, which would be taxable to investors. The company didn't respond to requests to comment.

Another potential tax trap: Since mutual funds are subject to arcane tax rules that also govern corporate mergers, a merged fund may be limited in its ability to use accumulated "capital-loss carryforwards." These accounting items are investment losses that can reduce tax bills by offsetting future gains. The Allianz RCM Global Technology fund lost much of its substantial carryforwards after it merged with the Allianz RCM Innovation fund last year. Phil Neugebauer, an Allianz Global Investors spokesman, says that many of the carryforwards were about to expire and that the merger cut the Global Technology fund's expense ratio by 0.15 percentage point, to 1.61 percent, "which is clearly a benefit to shareholders."

Combining Assets

As more mutual funds merge, investors should stay alert to signs pointing at potential problems.

Investors in an acquiring fund could suffer from weaker performance after a merger.

Combinations of funds with dissimilar strategies can have negative tax consequences.

Investors should consider whether a planned merger could derail their investment objectives.