Choose mutual funds and ETFs with a minimum portfolio size that is economical
If you are going to invest in actively managed funds, then you should want them to have a sufficiently large asset base to fund the necessary research.
If an active fund is too small, then fund management quality can suffer or fees could grow. Passively managed index funds and ETFs do not have the significant overhead that active funds have associated with personnnel to evaluate investment alternatives. Because of their much lower analytic costs, the minimum size of passively managed index funds and ETFs can be less an issue than it is with an actively managed fund. Nevertheless, both actively managed funds and passively managed funds have to cover their marketing, sales, legal, customer service, and other costs - many of which benefit from economies of scale related to the amount of assets under management.
To amortize the management expenses that are necessary to manage properly a mutual fund or ETF each year, some minimum total asset figure is required.
To illustrate, an actively managed $100M equity mutual fund with a 1% expense ratio yields $1 million annually for analytic expenses and other fund management costs. In the grand scheme of what it takes to run a mutual fund or ETF each year, $1M is just not a lot of money. Therefore, it would be reasonable for you to set your minimum asset selection criteria at several hundred million dollars or even higher for any diversified investment fund -- particularly those that are actively managed. (Also, see these companion articles: Choose sufficiently mature mutual funds and ETFs and Avoid very large actively managed mutual funds and ETFs)
If your maximum annual management expense screening criterion were lower than 1%, then the required asset base would need to be proportionately higher. If the expenses of a particular “style” of active fund, such as emerging markets equities, tend to be significantly higher, then you would want an even larger asset base over which to spread portfolio management costs.
While the scientific investment literature indicates that passive index fund strategies lead to better net performance on average, The Skilled Investor does not expect that actively managed funds will disappear. Therefore, if you still are going to invest in any investment fund and particularly actively managed funds, then you should want them to have a sufficiently large asset base to fund the necessary research and pay all other administrative costs. If a fund is too small, then fund management quality could suffer and/or fees will increase.
With actively managed funds, the problem is not that there is no “gross” value added. On average, fund management professionals make a slightly positive contribution before their expenses. They may be doing so at the expense of amateurs who are poor portfolio self-managers. (See: What is the cost to individual investors of sub-optimal portfolio diversification?)
The problem with active professional management is that, on average, they charge substantially more than they return in improved performance.
The average active managers just does not make a sufficiently great incremental contribution to overcome his substantial added costs. Furthermore, there is no reliable way to tell future winners versus losers from among active professional managers. Therefore, in “net” rather than “gross” terms to individual investors portfolios, it is far more likely for active managers to trail rather than exceed a passive market index return.
There are significant differences in costs between actively managed funds and passively managed index funds. By not attempting to beat the market, which most often will meet with failure, index funds can dramatically reduce costs and taxes and improve the odds of better net returns. While there are some areas of specialized expertise in index fund management, properly managing an index mutual fund depends largely on having a very efficient trading operation to track the index and an efficient customer service back-end.
Index mutual funds and ETFs do not have the significant overhead that active funds do associated with evaluating investment alternatives. Therefore, the demand for expensive staff is greatly reduced.
Because of their much lower costs, the minimum size of passively managed index funds is less of an issue than it is with actively managed funds. Nevertheless, individual investors still need to be concerned about index funds that are too small. With an index fund, The Skilled Investor suggests that you screen index funds using the maximum expense ratio that you will personally tolerate. If an index fund is run efficiently, then their expense ratio should be very, very low. While there are some ridiculous examples of domestic index funds with expense ratios over 1% annually, even a .25% upper screening limit will give you a wide range of funds from which to choose. (See: Choose mutual funds and ETFs with lower investment management expenses)
Finally, note that newly created, actively managed and passively managed funds that are spawned within a larger fund family may benefit for a time from both the fund family’s economies of scale and its subsidies. Administrative economies of scale can permit new funds with smaller asset sizes to exist for a longer period. Often, fund families will also subsidize the expense ratio of their newer funds. This temporarily reduced expense ratio can have the effect of increasing short-term performance. However, if a new fund does not grow quickly, then it is likely to be shut down or merged into another inferior performing and/or more risky fund within that fund family. (See: Choose sufficiently mature mutual funds and ETFs)
________________________________________
These related articles may also be useful to you:
- Rational selection of bond mutual funds and equity mutual funds -- overview
- Avoid mutual funds with sales commissions and 12b-1 fees
- Avoid mutual funds with higher investment portfolio turnover
- Avoid very large actively managed mutual funds
- Choose sufficiently mature mutual funds
- Choose mutual funds with a minimum economical portfolio size
- Evaluate historical investment performance, but only after using other investment screening criteria
- Excessive investment costs are a huge problem for individual investors
- How much do hidden mutual fund trading expenses cost you?
- Beware of large and hidden mutual fund costs
- Invest in fixed income securities through bond mutual funds with low investment fees
- Is it worth paying higher bond mutual fund management fees?
- Passive individual investors are "free riders" who benefit from the higher costs of active traders
- The investment industry is not your investment partner