Money Matters: Managing mutual funds

Last week I talked about what is needed to manage your personal investments. I also provided a warning about the use of mutual funds. Many believe if your money is in a fund, there is no need to watch the fund or make additional decisions.

Unfortunately, that is just not so.

There are many "truths" about management of investments you should not bank on to achieve your retirement. One of those is assuming if your fund is with one of the large management companies, you have nothing to worry about. When you are seeking performance, size of the fund can matter; but generally, it is the opposite of what you or tens of thousands
who have invested in some of the largest funds think.

As of Aug. 31 per Morningstar®, the 20 largest funds by share class are dominated by three fund companies - Vanguard, Fidelity, and American Funds. Surprisingly, American Funds is the management company with the most funds in this group of 20; they have 8 funds listed. This is unexpected, because this is a load fund family, one charging commissions to the investor and is sold by brokers. Fidelity is next with 5 funds and then Vanguard with 4 funds, each of these fund families having a money market fund as part of their group.

Per Morningstar, the benchmark for these funds is the S&P 500, which for the last 10 years has averaged 8.91 percent per year. Of the 15 funds for the above investment management companies (ignoring the two money market funds) most managed to equal or surpass the benchmark’s performance for the last 10 years. There are financial columnists writing that few funds actually outperform the averages and suggest you should invest in index funds. Another management company prides itself on low expenses and suggests in many of their ads low fund expenses will outperform those with high
expenses. Of these 15 funds, only three are index funds and they achieved their target performance, the index’s return.

If you are to believe the truth that few funds outperform the index, you would be wrong. Of the remaining 12 funds, 11 beat the benchmark and the index funds, and most doing so with a ten year average annual return did so by more than 2 percent per year.

Each of these funds manages more than $36 billion. Obviously, there are tens of thousands of individuals investing in these funds, many of whom believe there is either safety in the size or performance. The ten year average annual return ranged from 7.47 percent to 15.59 percent for the 15 funds reviewed above. Looking at funds who manage at least $100 million but less than $1 billion, there are 2,003 funds with a 10-year history. Of these, more than one-fourth has grown more than the benchmark for the last 10 years ranging from 8.92 percent to 22.80 percent per year. While many individuals gravitate to large funds believing in some cases they are safer; in my opinion, you are often sacrificing performance by doing so.

Large funds by their very nature are restricted to investing in larger companies and taking larger stakes with each purchase. The number of holdings often dilutes the performance, and it is harder for the fund manager to exit a strategy without causing the price to fall even more with their own sell orders.

Funds managing less than $1 billion often have fewer holdings in their fund at any one time. While they remain diversified, the gains of their better picks are not diluted by too many holdings. They can also invest in smaller companies or small positions in firms. All of this may assist them in achieving higher returns than their behemoth counterparts.

Many studies have been performed evaluating the number of funds and types of funds that should be held to achieve higher performance with a reduced risk. I am still amazed by the number of new clients I see with all of their retirement money in just a few funds; and in some cases, their funds have performed poorly for a number of years. Placing all of your eggs in one or a few baskets does not work for investing. A review of returns of the market segments will disclose there is no consistency for where the returns will occur. If you are only invested in a couple of the segments of the economy, then most likely you will miss the best performing segments resulting in lower average returns. Thus, concentrating in just a few funds may also cause your long-term average to be lower.

If you have the time and are dedicated to do the research, monitoring, and tracking, then managing your own investments may work. However, just like the skill or profession of your work, not everybody can do the task well and should be in that job. Just because you may have the time and are willing to do the research, your results may not merit you doing the job alone.

Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville TN 37801. Be sure to mark your envelope Money Matters.

Doug Horn, CFP, is an area financial planner with more than 21 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.

Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member NASD, SIPC.

© 2006 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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