Avoid Very Large Actively Managed Mutual Funds

Avoid very large actively managed mutual funds

Big actively managed mutual fund portfolio positions and higher percentage ownership of any company’s bonds or common stock are not good things for actively managed mutual funds. Nor, are these big positions and high percentages good for you.

Large portfolio size constrains how efficiently an actively managed mutual fund can trade.

When an actively managed mutual fund becomes very large, it must manage its trading exceptionally well or it will suffer significantly higher transactions costs, which tend to cause lower net performance.

There are some extremely large mutual funds. On January 26, 2007, Morningstar, Inc. data indicated that the total net assets of the largest U.S. domestic mutual funds ranged from $161.9 billion for the largest mutual fund to: $45.0 billion for #10, $25.1 billion for #20, $19.0 billion for #30, and $14.3 billion for #40.¹ Only a few of these very large mutual funds were passively managed index funds, and the rest were actively managed mutual funds.

Is there a maximum mutual fund size that might affect investors’ welfare negatively? A larger mutual fund can afford more analysts and can increase the number of different company securities that it holds. However, there are practical limits. The size of the positions held will also tend to increase.

Very large size can push some mutual funds into investing only in companies with very large market capitalizations.

With so much money to invest, it is not practical for these fund giants to track companies with smaller market capitalizations or debt issues. Many giant mutual funds have enough assets to buy smaller companies in their entirety, but all funds are constrained from doing so by laws and regulations — even if they wanted to so. Funds must avoid certain concentrated positions (e.g. not holding more than 5% of a company’s securities) that would jeopardize their legal standing as diversified management companies and their corporate tax exemptions at the fund management company level.

Even if they stay within these legal ownership limits, very large actively managed mutual fund size inevitably increases the fund’s percentage ownership of the securities that it holds. A notable issue faced by very large and large actively managed mutual funds is the ‘market impact’ of the fund’s trading activities. If the mutual fund tries to buy or sell large positions in individual firms over short periods, the fund can adversely affect the market price of that security temporarily.

When large funds buy or sell, there must be sufficient trading volume on the other side. A sufficient volume of trades by others with contrary opinions of a company’s prospects must be available. If not, the market bid/ask price range must adjust temporarily to encourage others to enter the securities markets to trade.

Trading induced changes in securities prices can drag down the net returns of very large actively managed mutual funds in particular.

However, mid-sized mutual funds can also suffer adverse market impact. If the positions traded by mid-sized funds are substantial relative to the total available short-term trading volume, they will also suffer negative market impact. However, this market impact problem tends to be the more acute with larger funds.

Given these considerations about the size of very large actively managed mutual funds, you may wish to set a limit on the maximum size of mutual fund, in which you are willing to invest. You might decide that you are not willing to put your money into funds that exceed perhaps $10 billion or $5 billion in assets or even less. There is no magic excess size threshold, but you should be aware that you can choose from numerous funds with assets under $10 billion or $5 billion.

Many monster-sized actively managed funds receive significant publicity. They charge high fees on a large asset base and have plenty of money for promotion. Furthermore, the financial media tends to write more about them, because they are larger and held my more investors.
You should keep in mind that your familiarity with the brand name of a mutual fund or fund family does not mean this larger fund is “better” than a smaller one that you may not recognize. Large fund performance could be worse, given trading costs and other management problems. Familiarity or lack of familiarity with a mutual fund brand name should not be considered when you screen funds initially.

Brand awareness often is simply an indicator of a fund family’s higher marketing and advertising costs that fund shareholders tend to pay one way or another. If other screening criteria indicate that a fund could be attractive, the fact that it is an unfamiliar fund should have absolutely no bearing on whether you decide to do more investigation.

When an actively managed mutual fund’s size grows very large, its portfolio holdings may also move closer to the composition of the market index.

There is strong evidence that the portfolios of many very large, large, and even medium sized actively managed mutual funds closely resemble the composition of the passive indexes against which their performance is benchmarked. However, the annual percentage expense ratios of these actively managed funds are far higher than the annual percentage fees of passively managed index funds. Active mutual fund shareholders are charged much higher annual expense ratios across both the active and passive portions of their portfolios. In effect, you pay an extremely high asset management fee across all fund assets for only a much smaller portion of real active management.

Large size is a far greater concern with actively managed mutual funds than for passively managed index mutual funds or ETFs.

Very large passively managed index funds do far less trading, because they trade only to invest net inflows or to redeem net outflows. In contrast, large actively managed funds incur much higher trading costs in pursuit of better returns, which raises the hurdle than they must get over just to break even on these attempts.

While ETFs are a much newer investment vehicle than mutual funds, the largest U.S. diversified domestic ETF held $85.1 billion and the 10th largest held $10.9 billion.²Unlike mutual funds, ETF’s short-term trading strategies are exposed, because ETF shares are created daily. Therefore, we do not yet have actively managed ETFs, and those marketed today track indexes - however esoteric. However, there are some ETFs that are quasi-active, because their portfolios are reconstituted periodically.

If you are considering investing in a very large actively managed mutual fund, you should think about the alternative of investing in an index mutual fund or ETF that targets the same benchmark. Index funds do significantly less trading through their buy-and-hold strategies. They have a lower likelihood of a performance short fall due to their market trading impact. Of course, index mutual fund expenses should be substantially lower, which is likely to improve performance. If you choose an ETF, be careful to select for low management costs and watch your brokerage fees.

1) http://screen.morningstar.com/FundSelector.html This is Morningstar.com’s free mutual fund screener.
2) http://screen.morningstar.com/ETFScreener/Selector.html This is Morningstar.com’s free exchange traded fund screener.