Choose Mature Noload Mutual Funds
Investing in more mature stock and bond mutual funds 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 bond mutual funds.
Very young mutual funds simply lack records of accomplishment. Therefore, very young stock and bond mutual funds 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 mutual funds 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 mutual funds 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 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 the structure of the sales compensation paid to the investment counselor or financial advisor who convinces you to invest in stock and bond mutual funds. 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 bond mutual funds 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 stock mutual funds, 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 mutual funds 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. 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.”2
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.
Mutual fund companies tend to merge new, under performing mutual funds into their inferior mature mutual funds
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 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
