Wednesday, November 7, 2007

A Mutual Fund Too Successful to Succeed?

Suppose that you have found a mutual fund called XYZ with a good track record of strong returns and an honest manager who has not closed and renamed losing funds and has not incubated funds as discussed in my last post. Hurray!

XYZ fund manages $50 million making it small by mutual fund standards. The fund manager is very skilled at investing in small companies that are about to grow big. So, you switch out of your current mutual fund and switch into XYZ. This is going to be good!

The herd is with you.

It turns out that you weren’t the only person with this idea. Literally thousands of other people pile into XYZ chasing those high returns. Assets under management at XYZ swell to $2 billion, a 40-fold increase.

This is great for the fund’s managers; they will collect 40 times the management fees. But, what are they going to do with all that investor money? XYZ fund was successful at finding a handful of small companies that give big returns. These companies aren’t big enough to buy 40 times as much stock in each one. The fund managers worked hard to find 20 good investments, and suddenly they need at least 100 more investments, fast!

Something has to give.

XYZ’s managers quickly find several more small companies along with some larger ones and invest the whole $2 billion. However, these hasty investments turn out to be nowhere near the quality of their picks back when XYZ was small, and a year later, the returns are very disappointing. XYZ has turned into just another mediocre fund. You got into this fund too late to make any money.

This illustrates the danger of chasing high-returning funds – you get mediocre returns and keep paying fees and possibly loads for switching in and out of funds frequently.

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