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Exploring Mutual Funds – Warning Signs

Ray Calleja

An article written by Ray Calleja: Head – Private Clients, MeDirect

With mutual funds, like with everything else, things can go wrong and as an investor you must be aware of red flags, which may indicate that all is not well in some of the funds that you are invested in. Today we will discuss some of the warning signs that you need to look out for. If you do spot a red flag it does not automatically mean that you need to sell but rather, you should investigate further.

Asset Growth

As funds attract new investors and grow larger, their returns often become sluggish, weighed down by too many assets. While there is no definite relationship between the size of a fund and its performance, it is believed that both, being too large and too small, can hinder a fund’s performance. There are obvious cost benefits with large funds – where economies of scale come into play. The fixed costs become a smaller proportion of the expenses thus improving the efficiency of the fund. A large fund will also bring in increased revenue for the fund house from its management fees. If used effectively, these benefits can be passed on to the investors.

However, when a fund is unable to maintain its own investment strategy and fails to continue to produce returns comparable to the fund’s historical record, then the fund has become too large. This is not a problem for index funds and bond funds, where the bigger the size the better it is, since this should mean a reduction in a fund’s expense ratio.

Nevertheless, the size of a fund must be looked at in relation to its investment style. This is particularly true for funds which invest in specific sectors or those which are thematic funds (e.g. an infrastructure theme fund). The same applies for mid-cap or small-cap funds because if a mid-cap or small-cap fund becomes too large, it cannot invest solely in mid-caps or small-caps due to concentration risk in individual stocks, not to mention that mid-cap or small-cap stocks can be illiquid. Large scale buying or selling by the fund can lead to a massive impact on the price of mid-cap or small-cap stocks. When these funds become bigger because they are attracting new investors, the challenge is on for the fund manager, who may see his/her performance slip as he/she tries to find new investments with the new influx of cash.

This does not mean that smaller is always better. Smaller funds may show better short-term performance but this could be attributed to a few successful stocks in the portfolio, which could have a big impact on the performance of the fund. Such funds may also not have a long track record, and their fund managers may well be inexperienced. These types of funds tend to be less diversified with the result that one stock may have a major impact on the overall portfolio if it suffers from a downturn. Operating expenses also tend to be higher with smaller funds, which is the contrary to what we spoke about, earlier.

Therefore, when it comes to asset size of your mutual fund always consider the size in relation to the investment approach. You should also be wary when you see that the asset base of the fund is shrinking. This could mean that either there have been major outflows from the fund, due to investors withdrawing their investment or value of the assets in the portfolio have fallen considerably.

Another red flag is the amount of cash being held by the fund. Has this increased compared to previous years? Although a small proportion of the fund must be held in cash to meet any redemption requests from its shareholders, a large cash holding – usually above 15% of its total portfolio value – may indicate that the manager is having difficulty allocating the fund’s assets to various securities. Some still may argue against such threshold as they maintain that holding a relatively large amount of cash will give them the opportunity to take full advantage in situations where they anticipate a market correction or downturn.

The bottom line is that you must continue to monitor a mutual fund you are invested in to make sure that its strategy is matching the fund’s original objectives and goals. If not, then it may be time for you to sell that fund.

Change of Fund Manager

In previous articles, we discussed the importance of the fund manager since he/she is responsible for a fund’s performance and he/she is the person who makes all the important decisions about buying and selling the portfolio of securities making up the fund’s assets. So, when a fund manager leaves many wonder if they should sell their fund. The answer is not always yes.

When a fund manager does leave, the fund house will claim that it is business as usual. Obviously, you will need to take that with a pinch of salt and delve deeper before taking any action. Was the manager the only person at the helm or was he part of a larger team? Some fund houses follow a common investment philosophy and are process-driven. In such circumstances, fund managers are asked to follow a common philosophy and are not allowed to deviate from it. If your fund comes from a fund house with such a policy the exit of a fund manager may therefore not have a huge impact.

You must also try to find out more about the new manager who will replace him or her. What about his/her track record and experience? If the new person has a good and long track record at a similar fund, then that should make your decision easier and you are likely to stay put. If it is a manager who has been with the fund house but does not have much of a record, then take a look at other funds of the company in the same asset class. Some fund houses have an excellent track record and are able to replace departed fund managers without much disruption and effectively.

Good managers build good teams around them and that can endure after their departure, giving an incentive to stay with a fund even if the manager leaves. Even though everything always starts with the leader, as long as the new manager can maintain the fund’s ethos and get the best from the team, things should be fine. 

A change in the fund manager will make a difference only in certain circumstances. If the fund you own is an index fund it should not really make any material difference if the manager leaves, since that fund is meant to be tracking a defined benchmark, anyway and are not actively choosing stocks.

Finally, it is also important to find out whether the incoming fund manager will be adopting a new strategy to the fund. If that happens, then you do need to ask yourself the question whether the new strategy still fits in with your investment objectives. A fund’s value will not be affected overnight, so you will have sufficient time to assess the situation and then decide whether you want to stay or leave your investment in that fund.

Fund House Mergers or Acquisitions

In the last few years, we have witnessed several mergers and acquisitions, with the most prominent one in 2020 being the acquisition of Legg Mason by Franklin Templeton. Such transaction is another way to unlock economies of scale. Before that, there were other large asset management firms such as Aberdeen and Standard Life, along with Janus and Henderson which merged. More and more of these mergers are happening, since acquisitions are a quick way to grow the asset base and/or to expand the footprint of asset managers in markets where they haven’t been active in the past. Change in the European and global funds industry is not driven only by regulations and earnings pressure on asset management firms. It is also driven by investor demand, since investors ultimately decide in which funds to invest.

However, changes in ownership can also have a negative impact and may lead to a slow-down in performance or even to departures by fund managers and their teams shortly after a firm is sold to another company. It is therefore important for you to stay informed on the latest news on fund houses and their growth plans and new fund launches by visiting the MeDirect website, which is constantly updated with the latest news from the industry, not to mention the fund houses’ own websites and other financial news portals. Do take note of what independent sources have to say about your funds and their fund houses. Our partners Morningstar do not sell their own funds and their role is to be a watchdog in this field. Read their fund analysis and reports, also available on the Medirect website.

To recap you should do a regular check-up, say once every one or two months, to make sure that things have not changed with your mutual funds. Have the assets grown suddenly? Are their fund managers still in place? Is there anything unusual going on with the fund house? If you find out that there have been changes or changes are in the offing then do ask questions. If you are unsure, don’t ignore. Instead, you should be speaking to your Financial Advisor.

The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties.

MeDirect Bank (Malta) plc, company registration number C34125, is licensed by the Malta Financial Services Authority under the Banking Act (Cap. 371) and the Investment Services Act (Cap. 370).

The financial instruments discussed may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in any of the products discussed you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

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