Posts Tagged ‘mutual fund management’

Avoid Very Small Mutual Funds and ETFs

If you are going to invest in actively managed mutual funds, 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 mutual funds 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 mutual funds and passively managed mutual funds 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 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% 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 mutual funds 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 mutual funds.

If the maximum 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 mutual funds 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 mutual funds, 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 mutual funds 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 mutual funds and ETFs do not have the significant overhead that actively managed mutual funds 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 mutual funds. Nevertheless, individual investors still need to be concerned about index funds that are too small.

With , The Pasadena Financial Planner suggests that you screen for no load index funds using the maximum that you will personally willing to tolerate. If 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 . 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 of their newer funds. This temporarily reduction of the 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.

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