Choose mutual funds and ETFs with a minimum economical portfolio size

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. Index funds do not have the significant overhead that active funds have, which is associated with evaluating investment alternatives. Because of their much lower costs, the minimum size of passively managed index funds can be much less an issue than it is with an actively managed fund.

To amortize the management expenses that are necessary to manage properly an actively managed 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 management expenses.

In the grand scheme of what it takes to run an actively managed 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 an actively managed equity mutual fund.

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 even higher, then you would want an even larger asset base over which to spread active 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 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 could suffer and/or fees could grow.

The problem with active professional fund management is not that there is no “gross” value added. On average, fund management professionals make a 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 added cost, and there is no reliable way to tell future winners versus losers among active professional managers. Therefore, in “net” rather than “gross” terms, it is more likely for active managers to trail 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 an efficient trading operation to track the index and an efficient customer service back-end.

Index funds 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 much less of an issue than it is with actively managed funds. However, you should expect that passively managed index funds will have significantly lower expense ratios. With significantly lower annual expense ratios, index funds still need a reasonably substantial asset base to fund their management costs.

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.

Finally, note that newly created, actively 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 an inferior performing and/or more risky fund within that mutual fund family.