Choose sufficiently mature mutual funds and ETFs

Summary: Investing in more mature equity and bond mutual funds and exhanged-traded funds (ETFs) allows you to evaluate the historical consistency of a fund's record.

On average, the future portfolio returns of more mature funds are probably no more predictable than for very young funds with a similar style or strategy. However, the record of accomplishment of a more mature fund can provide more confidence in its commitment to its strategy and in its ability to remain in business. While there is no guarantee that an older fund will not fail, you have a better chance to avoid involuntary participation in the frenetic birth and death process of many infant funds.

Very young funds simply lack records of accomplishment. Thus, very young funds are more likely to put you in the position of being an experimental guinea pig. Concerning screening criteria, simply set a minimum age for funds you are willing to have in your portfolio. Three years should be adequate, and there is probably no reason to have a higher minimum. The point is simply to avoid allowing the industry to experiment with your money.

Keep in mind that the financial securities industry is very clever and tries very hard to attract your investment dollars. Data from Lipper, Inc. indicates that 1,460 new mutual funds were started in 2003, 2,309 in 2002, and 2,392 in 2001.1 The actual number of truly new and distinct funds is smaller, because Lipper counts different share classes as separate funds. Differences between share classes have nothing to do with the management of a fund's portfolio. Instead, these share class differences are due to structure of the sales compensation paid to the advisor who induces you to invest in a fund. Different share classes simply assess higher or lower front-end and back-end sales load charges and higher or lower annual expense ratios. 

Mutual fund and ETF companies might argue that they are trying to offer innovative new funds to meet evolving investor demands. A true innovation motive is quite unlikely, because thousands of funds of all types already exist. In 2005, there were almost as many different domestic equity mutual funds, as there were domestic publicly traded companies (U.S. firms that aretraded on public exchanges, excluding OTC penny stocks).

A more cynical view of this frenetic fund birthing process is that mutual fund and ETF companies recognize that fund performance is much more a matter of luck than skill.

If fund families keep forming new funds, then some of these new funds will perform better by chance than the average fund within their style categories.

The large number of new funds launched annually indicates that barriers to entry are very low. Fund families can launch a new fund and use their existing operations to support the new fund. If early fund returns happen to exceed its benchmark, then the fund family has a new fund to sell with a short but apparently superior performance record.

Sometimes, new fund managers will get lucky by taking positions in smaller firms with more volatile stock prices, or they may pick larger capitalization firms whose stocks fortunately appreciate more in the short run. The very short, but apparently stellar, record of accomplishment of some new funds makes it much easier to attract investors. These funds can live to see other days, if new assets grow fast enough.

You should pay close attention the expense ratios of a very young fund and the expense-related footnotes in its prospectus. It is common for fund families to subsidize the management expenses of new funds for a time. If the fund’s securities selection is lucky, then more investors may come running. Asset base growth then enables a fund to grow its management expenses without increasing its annual expense percentage.

However, if a fund is not so lucky, its standalone management expenses do not disappear. Fund families do not want to subsidize costs of their small, languishing funds for an extended period, and the pressure will be on for the fund to “stand on its own.” Therefore, you need to watch for upward creep in the expense ratio of a very young fund over time. Note that the higher a fund's expenses, the more likely it is that the fund’s net returns will fall short, when compared to a passive market index benchmark.

A mutual fund that does poorly will often be put out of its misery, although this mortality process will do nothing for the misery of the mutual fund's investors.

Most of these underperforming fund dogs (or puppies) either will be shut down or will be merged into larger funds. For example, “according to data from Lipper Inc. 870 U.S. mutual funds were merged into other funds (in 2003), while 464 were liquidated. The pace is similar to 839 mergers and 555 liquidations in 2002, and 956 mergers and 433 liquidations in 2001.”

As noted previously in this article, 1430 mutual funds were created in 2003. When 2003’s 870 mergers and 464 liquidations are combined with these new funds, then the net number of new mutual funds was just 96! Fund financial innovation certainly seems like an awfully harsh process, through which many investors find themselves being dragged. The cynic would say that the mutual fund industry’s rapid birth and infanticide cycle simply allows some of the fund industry's inferior performance history to be swept under the carpet and obscured or erased.

Furthermore, to the chagrin of participating investors, when unsuccessful young mutual funds are merged, there also is evidence that the older mutual funds into which these young, failed funds are merged will usually have inferior characteristics from the investor’s perspective. The larger and older existing funds into which new and unsuccessful funds are merged have a higher tendency to be both more risky and poorer performing than the average fund.3 

Apparently, many fund families do not want to lose the assets already in their inferior new funds by liquidating them and issuing refunds. However, at the same time, they appear not to want to merge these failed young funds with their more successful older funds and thereby drag down the performance history of these more successful older funds. Instead, they usually merge their sick puppies with their older dogs, which have become large enough to stay alive.

1) Hayashi, Yuka. “More Mutual Funds are Disappearing Despite Market Recovery.” Dow Jones Newswires. February 26, 2004.
2) ibid
3) Edwin J. Elton, Martin J. Gruber, and Christopher R. Blake. “Survivorship Bias and Mutual Fund Performance.” Review of Financial Studies, Winter 1996, Vol. 9, No. 4: pp 1097-1120

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