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Avoid Large Actively Managed Mutual Funds

Big mutual fund portfolio positions and higher percentage ownership of any company’s stocks and bonds are not good for actively managed mutual fund performance.

These big positions and high percentages are not good for your personal investment portfolio either. Large size constrains how a fund can trade and how efficiently it can do so. When an actively managed mutual fund becomes very large, it must manage its trading exceptionally well, or it will suffer significantly higher transactions costs, which tend to cause lower net mutual fund performance. The need to balance short term securities market trading supply and demand will drive up trading costs for actively managed mutual funds.

There are some extremely large mutual funds. For example on January 26, 2007, Morningstar, Inc. data indicated that the total net assets of the largest U.S. domestic mutual funds ranged from $161.9 billion for the largest mutual fund to: $45.0 billion for the number 10 US mutual fund, $25.1 billion for #20, $19.0 billion for #30, and $14.3 billion for #40.1

Only a few of these very large stock and and ETFs were passively managed no load .

The rest were actively managed mutual funds. All share classes for each fund, including share classes with front end loads and back end loads, were grouped together for these total asset numbers. While exchange traded funds (ETFs) are a much newer investment vehicle than mutual funds, their characteristics are more similar than different.

In general, individual investors can use mutual funds and ETFs interchangeably, if they follow the “7 Ways to Pick the Best Noload Mutual Funds and ETFs” The largest U.S. diversified domestic ETF held $85.1 billion and the 10th largest exchange-traded fund held $10.9 billion.2

Keep in mind that the large investment portfolio size issues and the market impact issues discussed in this article are much more significant concerns for actively managed mutual funds. They are not as important for and for ETFs that track passively managed market indexes. This is simply because very large do far less trading.

Because of how ETFs are constructed, the ETFs that have been introduced thus far for purchase by individual investors tend to be indexed and therefore more similar to passively managed . Unfortunately, the vast majority of ETFs on the market now track relatively narrow sector index benchmarks. This leaves undesirable industry sector volatility in your portfolio, when compared to broader based market indexes that diversify across all market segments.

The composition of an ETF’s portfolio is transparent and known to the market on a daily basis. Portfolios of actively managed mutual funds are only known publicly a few times a year. Therefore, mutual fund portfolio composition becomes public long after trading changes have been made.

Given this exposure of an active ETF’s trading strategy almost in real time, there is concern that other traders in the market might front run an actively managed ETF. This has slowed the introduction of actively managed ETFs, although some are coming to market. Nevertheless, there already are some ETFs that do reconstitute their portfolios periodically and these ETFs can be viewed as quasi-actively-managed.

With no load , the target composition of their portfolios can be known through the benchmark index.

The composition of a particular no load index fund may vary from the index, but usually only by a small amount. The target portfolio composition changes only when the publisher of the underlying bond or stock market index changes the composition of the index. When the index changes, then must make changes, and this can have a market trading impact. Adverse market impact raises transaction costs and lowers net mutual fund or ETF performance.

Is there a maximum stock and bond mutual fund size of actively managed mutual funds that might affect investors’ welfare negatively?

A larger fund can afford more analysts and can increase the number of different company securities that it holds. However, there are practical limits. The size of the positions held will also tend to increase. Very large size can push some funds into investing only in companies with very large market capitalizations.

Many of these very large funds become defacto , because their holdings tend to replicate a large portion of the benchmark securities index, while they charge higher fees and more often deliver inferior net performance after their added investment expenses and costs.

With so much money to invest, it is not practical for these fund giants to track companies with smaller equity market capitalizations or debt issues. Many giant mutual funds have enough assets to buy smaller companies in their entirety.

However, all diversified investment funds are constrained from doing so by laws and regulations — even if they wanted to so. For example, funds must avoid certain concentrated positions (e.g. not holding more than 5% of a company’s securities) that would jeopardize their legal standing as diversified management companies and their corporate tax exemptions at the fund management company level.

Even if they stay within these legal ownership limits, very large actively managed fund size inevitably increases the fund’s percentage ownership of the securities that it holds. A notable issue faced by very large and by large actively managed mutual funds is the “market impact” of the fund’s trading activities.

If the fund tries to buy or sell large positions in individual firms over short periods, the fund can adversely affect the market price of that security temporarily. When large funds buy or sell, there must be sufficient trading volume on the other side. A sufficient volume of trades by others with contrary opinions of a company’s prospects must be available. If not, the market bid/ask price range must adjust temporarily to encourage others to enter the securities markets to trade.

Trading induced changes in securities prices can significantly drag down the net investment performance of very large actively managed mutual funds.

In addition, mid-sized mutual funds can also suffer adverse market impact. If the positions traded by mid-sized funds are substantial relative to the total available short-term trading volume, they will also suffer negative market impact. Nevertheless, this market impact problem tends to be the more acute with larger funds.

Given these considerations about the size of very large actively managed mutual funds, you might wish to limit the maximum size of the actively-managed mutual fund or quasi-actively-managed ETF, in which you would be willing to invest. You might decide that you are not willing to put your money into funds that exceed perhaps $10 billion or $5 billion in assets or even less. There is no magic excess size threshold. Nevertheless, you should be aware that you can still choose from numerous funds with assets under $10 billion or $5 billion that still meet the other screening criteria from the “7 Ways to Pick the Best Noload Mutual Funds and ETFs.”

Many monster-sized actively managed mutual funds receive heavy publicity.

You should keep in mind that your familiarity with the brand name of a mutual fund or with the names of mutual fund companies does not mean a larger fund is “better” than a smaller one whose name you may not recognize. In fact, because of the problem that investment portfolio performance could be worse for large and very large actively managed mutual funds, well known brand names might deliver worse performance over the long term.

If well recognized actively managed mutual fund brand names attract excessive asset inflows, this will cause higher trading costs, greater “market impact,” and other investment management problems. In addition, the portion of their portfolios held in cash can increase, and you will get charged the same high management expense ratio for the cash, as well as, the stock and bond holdings.

Familiarity or lack of familiarity with a mutual fund brand name should not be considered when you screen funds initially. Brand awareness often is simply an indicator of a fund family’s higher marketing and advertising costs that fund shareholders tend to pay one way or another. If other screening criteria indicate that a fund could be attractive, the fact that it is an unfamiliar fund should have absolutely no bearing on whether you decide to do more investigation of an unfamiliar mutual fund — preferably a no load index fund.

Understand that large mutual fund portfolio size is a far, far greater concern for actively managed managed funds than for passively managed and ETFs that track bond and stock market indexes.

Very large passively managed do far less trading, because they trade only to invest net inflows or to redeem net outflows. In contrast, large actively managed funds incur much higher trading costs in pursuit of better returns, which raises the hurdle than they must get over just to break even on these attempts.

With an actively managed mutual fund, for example, the mutual fund manager or managers can simply decide to change the composition of the investment portfolio and incur the trading cost and market impact. Every mutual fund manager hopes to gain more than the incremental trading costs, when they do this.

Of course, when all these collective buy and sell decisions are made, fund managers are more likely to be wrong than right. They have no crystal balls about what will happen to securities market values in the future. For every securities buyer there must be a seller and for every securities seller there must be a buyer. Actively managed mutual fund portfolios get rearranged, trading costs go up, and total net performance must come down.

If you are considering investing in a very large actively managed mutual fund, you should think about the alternative of investing in a noload mutual fund that targets the same index benchmark.

No load do significantly less trading through their buy-and-hold strategies. They have a lower likelihood of a performance shortfall due to their market trading impact. Of course, index fund expenses should be substantially lower, which is also much more likely to improve net investment performance.

As mentioned above, when an actively managed mutual fund’s size grows very large, its portfolio holdings may also move closer to the composition of the market index. There is strong evidence that the portfolios of most very large, large, and even medium sized actively managed mutual funds closely resemble the composition of the passive indexes against which their performance is benchmarked.

However, the annual percentage expense ratios of these actively managed funds are far higher than the annual percentage fees of passively managed . Active mutual fund shareholders are charged much higher annual management expense ratios across both the active and passive portions of their portfolios.

In effect, you pay an extremely high asset management fee for just a little active management. This is because you pay a higher management expense ratio across all fund assets, but only a much smaller portion of the investment portfolio is really being managed actively.

Of course, portfolio managers might disagree. Nevertheless, how do they explain the most likely outcome, which is to relatively closely track, but usually under perform the benchmarket? Whatever the reasons or excuses, you can decide if you want to keep paying high fees for closet indexers who under perform.

More often than not individual investors lose, when they hold actively managed mutual funds. The longer the time period is that investors hold actively managed mutual funds, then the smaller and smaller the chance is that they will actually “beat the market.” Sadly, this transfer of assets from individual investors to mutual fund companies has continued and has grown for decades. It is well past time for individual investors to wise up!

1) http://screen.morningstar.com/FundSelector.html This is Morningstar.com’s free mutual fund screener. Check the Sitemap for our articles about free online fund screening applications and databases.

2) http://screen.morningstar.com/ETFScreener/Selector.html This is Morningstar.com’s free exchange traded fund screener. Check the Sitemap for our articles about free online fund screening applications and databases.

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