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 [...]