Large active funds have a return advantage

Analysis of US-dollar denominated mutual funds indicates multiple factors that weigh on small funds’ returns

Large active funds have a return advantage

When deciding on a mutual fund, investors have to consider several factors: the fund provider, its asset-class exposure, the level of risk, and fees, just to name a few. And when it comes to active strategies, they may also want to look at assets under management.

That’s the conclusion supported by Derek Horstmeyer, assistant professor of finance at George Mason University’s Business School, who shared his analysis of US dollar-denominated, actively managed mutual funds in the Wall Street Journal.

Focusing on active funds with exposure to US stocks, international equities, and fixed income, he divided each asset-class segment by size, specifically separating small funds (those in the bottom quarter in terms of assets under management) and big funds (those in the top quarter). From there, he compared the returns that were achieved by each group over the past five years.

“I studied a five-year period (as opposed to a longer time frame) in an attempt to avoid any distortions that may come with poor-performing mutual funds being closed down after five-plus years of bad performance,” he said.

The analysis revealed that on average, the biggest funds managed to outperform their small counterparts by more than a full percentage point per year after taxes. Notably, small funds exhibited a much wider range of annualized returns over the past five years; small US equity funds, for example, had a 78% greater dispersion in returns than big funds.

“Small funds also had more turnover in their holdings,” he continued, noting that it suggested a more aggressive bid to beat markets that translates into a heftier tax bill for the average investor. The higher trading activity also showed in the volatility of performance, with small funds’ returns being more volatile than their big fund counterparts across all asset categories.

“On average, small domestic-equity mutual funds were 30% more volatile than their big-fund counterparts,” Horstmeyer said.

The three factors put together — a greater tendency to trade, wider dispersion of returns, and more volatility — spell a major post-tax performance disadvantage for small funds across the board. Horstmeyer repeated the analysis over shorter 1-year and 3-year time frames, and found that small funds still tended to underperform and exhibit wider returns dispersion than big funds.

“An argument can still be made for small funds in certain cases,” he said, noting that small funds that make bold bets can still beat the market in the short run. “But in the longer run—certainly within five years—a big fund is likely to give you a bigger payoff.”

 

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