Avoid very large actively managed mutual funds

Big 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 size constrains how a fund can trade and how efficiently it can do so. When an actively managed 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. Only a few of these very large funds were passively managed index funds, and the rest were actively managed mutual funds. All share classes for each fund were grouped together. 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.

Note: Keep in mind that large portfolio size and market impact issues discussed in this article are a more significant concern for actively managed mutual funds than for index mutual funds and for ETFs. Because of how ETFs are constructed, those ETFs that have been introduced thus far tend to be indexed and therefore more similar to passively managed index mutual funds. The composition of an ETF's portfolio is transparent and known to the market on daily basis. Portfolios of actively managed mutual funds are only known publicly a few times a year and fund composition becomes public long after trading changes changes have been made. Given this exposure of an active ETF's trading strategy almost in real time, there is concern that other traders in the market might front-run an actively managed ETF. Nevertheless, there are some ETFs that substantially reconstitute their portfolios periodically and these ETFs can be viewed as quasi-actively-managed. 

With index mutual funds, the target composition of their portfolio is known through the index. The composition of a particular index mutual fund may vary from the index, but usually only very slightly. The target portfolio composition changes only when the publisher of the underlying index changes the composition of the index. When the index changes, index mutual funds must make changes and this can have a market trading impact. 

Is there a maximum mutual fund size that might affect investors’ welfare negatively?

A larger 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 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 investment 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 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 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 significantly drag down the net returns of very large actively managed mutual funds. 

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 or quasi-actively-managed ETF, 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 funds receive significant publicity. 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.

You should clearly understand that large size is a far greater concern with actively managed funds than with passively managed index mutual funds or ETFs that track indexes. 

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.

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 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 fund expenses should be substantially lower, which is likely to improve performance.

On a related topic, 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.

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