Does Fund Size Erode Mutual Fund Performance?
Some investors prefer to invest in smaller mutual funds because they believe that a larger mutual fund produces lower returns. Larger mutual funds most often spend a lower percentage of their money on administrative costs and can pay fund managers more, but they also have to find more companies to invest in, or larger companies to invest in. Small and large mutual funds each have their own advantages and disadvantages.
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Research Costs
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A mutual fund's managers need to research every company in which the fund may decide to invest. If a small mutual fund pays its analysts $10,000 to produce a report on a company, it will also cost a large mutual fund $10,000 to produce the same report. The large mutual fund will spend less on each report in comparison to the amount of money it manages. Even if the large fund researches more companies, if it researches five times as many firms as a small fund but it has a hundred times the small fund's assets, it still spends a smaller proportion of money on research.
Attracting Investors
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Closing a fund is also a helpful sales tactic, even if it doesn't affect performance. The reputation of the closed fund improves, because other investors believe it is well-managed. A fund family, which offers several mutual funds, attracts investors to its other open funds when it closes one mutual fund. This explains why the fund managers would close the fund, because they would earn higher fees by managing a larger amount of money.
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Liquidity
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A larger fund can buy a large number of shares in a few big companies. Funds usually buy more shares in the companies the fund already owns stock in as the fund grows, because the managers have already ruled out competing firms as poor investments. Purchasing a large number of shares in the same company lowers returns. The large fund will pay a higher price because the stock price will increase once it starts buying shares, and it will receive less income because the stock price will drop when it starts selling shares.
Investment Options
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For a large fund, there may not be enough small companies available to invest in with the potential to provide high returns. If the fund is limited to growth firms, or a single sector such as technology, it will have even fewer investment choices. Some mutual funds, small-cap funds, only invest in small companies.
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References
- Journal of Financial and Quantitative Analysis: Liquidity, Investment Style, and the Relation Between Fund Size and Fund Performance; Xuemin Yan; September 2008
- Journal of Banking and Finance: Why Are Some Mutual Funds Closed to New Investors; Xinge Zhao; December 2003
- The Journal of Finance: How Does Size Affect Mutual Fund Behavior; Joshua M. Pollet, Mungo Wilson; December 2008
- California State University, Fresno: Smart Money and Small Funds
