Posts Tagged ‘management expense ratio’

Avoid Very Small Mutual Funds and ETFs

If you are going to invest in actively managed , then these funds need to have a sufficiently large asset base to fund the necessary securities research and analysis.

If an active fund is too small, then fund securities research, analysis, and management quality can suffer or fees could grow. Passively managed index funds and ETFs do not have the significant overhead that actively managed have associated with personnel to evaluate investment alternatives.

Because of their much lower analytical costs, the minimum size of passively managed index funds and ETFs can be far less of an issue, when compared with an actively managed mutual fund. Nevertheless, both actively managed and passively managed have to cover their marketing, sales, legal, customer service, and other costs – many of which will benefit from the financial economies of scale related to the amount of assets under management.

To amortize the management expense ratio that is necessary to manage properly a mutual fund or ETF each year, a minimum total asset base is required.

To illustrate, an actively managed $100M stock mutual fund with a 1% management expense ratio yields $1 million annually for securities research, analytic expenses, and other fund management costs. In the grand scheme of what it takes to run actively managed 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 any diversified investment fund — particularly those that are actively managed .

If the maximum management expense ratio you are willing to pay each year is 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 stocks, tend to be significantly higher, then you would want an even larger asset base over which to spread securities research and other portfolio management costs.

While the investment research literature indicates that passive index mutual fund strategies lead to better net performance on average, The Pasadena Financial Planner does not expect that actively managed will disappear. Therefore, if you still are going to invest in any investment fund and particularly actively managed funds, then you should want them to have a sufficiently large asset base to fund the necessary research and pay all other administrative costs. If a fund is too small, then fund management quality could suffer and/or fees will increase.

However with actively managed , the problem is not that there is no “gross” value added. On average, fund management professionals make a modest positive contribution before their expenses. They may be doing so at the expense of amateurs who are poor portfolio self-managers.

One major problem with active professional mutual fund management is that, on average, they charge substantially more than they return in improved performance.

The average active mutual fund management team does not make a sufficiently great incremental performance contribution to overcome their more substantial added costs. Furthermore, there is no reliable way to tell future mutual fund management winners versus losers from among all active professional mutual fund managers. Therefore, in “net” rather than “gross” terms for individual investor portfolios, it is far more likely for active managers to trail rather than exceed a passive market index return.

There are significant differences in costs between actively managed and passively managed index funds. By not attempting to beat the market, which most often will meet with failure, no load 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 having a very efficient trading operation to track the index and an efficient customer service operation.

No load and ETFs do not have the significant overhead that actively managed do associated with securities research, and therefore, the need for expensive securities research analysts is greatly reduced.

Because of their much lower costs, the minimum size of a passively managed index fund is less of an issue than it is with actively managed . Nevertheless, individual investors still need to be concerned about index funds that are too small.

With no load , The Pasadena Financial Planner suggests that you screen for no load index funds using the maximum management expense ratio that you will personally willing to tolerate. If no load are run efficiently, then their management expense ratios should be very, very low. While there are some ridiculous examples of domestic no load index funds with management expense ratios over 1% annually, even a .25% upper screening limit will give you a wide range of no load index funds from which to choose.

Finally, note also that newly created, actively managed and passively 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 of the management expense ratio. Administrative economies of scale can permit new funds with smaller asset sizes to exist for a longer period.

Very often, fund families will substantially subsidize the management expense ratio of their newer funds. This temporarily reduction of the management 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 another inferior performing and/or more risky fund within that fund family. Therefore, you should choose mature noload mutual funds instead.

Pasadena Financial Planner No Load Mutual Funds , , , , , , , , , , , , , , , , ,

Choose Mature Noload Mutual Funds

Investing in more mature stock and and exchanged-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 stock and .

Very young simply lack records of accomplishment. Therefore, very young stock and are more likely to put you into the position of being an experimental guinea pig of mutual fund companies and the ETF industry. Concerning screening criteria, simply set a minimum age for and ETFs that you are willing to have in your investment portfolio. Three years should be adequate, and there is probably no reason to have a higher minimum. The point is simply to avoid allowing ETF and mutual fund companies to experiment with your money. Choose low cost noload that have been around for at least three years.

The financial securities industry is clever and tries very hard to attract your investment mutual fund and ETF dollars.

For example, data from Lipper, Inc. indicated that 1,460 new 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 the structure of the sales compensation paid to the investment counselor or financial advisor who convinces you to invest in stock and . 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 companies and ETF companies might argue that they are trying to offer innovative new stock and to meet evolving investor demands.

This answer is largely rubbish. Mutual fund companies and ETF companies are trying to get your assets into their funds. A true innovation motive is quite unlikely, because tens of thousands of funds of all types already exist worldwide. For example, there are almost as many different US domestic , as there were U.S. publicly traded companies (This counts only U.S. firms that are traded on public exchanges and excludes over the counter (OTC) penny stocks.)

A more cynical view of this frenetic fund birthing process is that mutual fund companies 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 the particular investment style category.

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.

Small new with stellar investment fund performance records attract investor assets

Sometimes, new fund managers will get lucky by taking positions in smaller firms with more volatile stock prices, or they may pick some larger capitalization firms whose stocks might appreciate dramatically 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 flow in 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. By keeping the management expense ratio down, the funds can temporarily inflate performance.

If the fund’s securities selection is lucky, then more investors may come running. If the asset base grows quickly enough then could enable the new fund to grow its management expenses without increasing its annual management expense ratio.

However, if a mutual fund is not so lucky, its standalone management expenses will 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 management expense ratio of a very young fund over time. Note also 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.

The new mutual fund grindhouse: Toss ‘em out — Chew ‘em up

In the Warner Brothers movie 300, the Spartans tossed to their deaths those babies whom they deemed to be inferior. Mutual fund companies also are Spartan in this respect. Unfortunately, most mutual fund companies do not extend this Spartan mentality to the management expense ratios that they charge investors across all their funds.

A new 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 under performing 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. 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.”2

As noted previously in this article, 1430 were created in 2003. When 2003’s 870 mergers and 464 liquidations are combined with these new funds, then the net number of new 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.

Mutual fund companies tend to merge new, under performing into their inferior mature

Furthermore, to the chagrin of participating investors, when unsuccessful young are merged, there also is evidence that the older — into which these young, failed funds tend to be 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 mutual fund.3

Apparently, many mutual fund companies do not want to lose the assets that they already have captured in their inferior new funds by liquidating them and issuing refunds. However, at the same time, they also 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 are large enough to stay alive within the cost structure of the mutual fund companies.

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

Pasadena Financial Planner No Load Mutual Funds , , , , , , , , , , , , , , , , , , ,