When it comes to portfolio liquidity, diversification matters.Why Mutual-Fund Portfolios Have Become More Liquid
What to Look for in a Mutual Fund Apart from Performance
- February 21, 2018
- CBR - Finance
When evaluating mutual funds, many investors look first at performance, even though a fund’s performance is inherently backward looking. They might want to look instead at several other characteristics as a “richer source of insights into the economics of mutual funds,” according to research by Chicago Booth’s Lubos Pastor and Wharton’s Robert F. Stambaugh and Lucian A. Taylor.
The researchers analyzed 2,789 mutual funds that were actively managed between 1979 and 2014. They find four characteristics of particular interest: fund size, expense ratio, turnover, and portfolio liquidity.
These characteristics appear to be closely related. Larger funds have lower expense ratios. Funds with lower turnover are larger and, again, have lower expense ratios. “Funds with more liquid portfolios should be larger and cheaper, and they should trade more,” write the researchers.
Research explores how investors react to sustainability ratings.Do Investors Want Companies That Are More Sustainable?
A fund’s size relates not only to its expense ratio but also to the other two fund characteristics. Specifically, larger funds have lower turnover and higher portfolio liquidity. Because of their size, larger funds cannot afford to trade too much, or to hold an illiquid portfolio—an indication of diseconomies of scale in active investing. But the size handicap can be partially overcome by skill.
“A more skilled fund can more effectively offset higher trading costs associated with a less liquid portfolio,” Pastor, Stambaugh, and Taylor write. For example, a fund with a skilled manager “can afford to concentrate its portfolio on its best ideas or to trade its less liquid stocks, which are more susceptible to mispricing.”
In the data the researchers analyzed, actively managed funds became more liquid over time as portfolios diversified to keep up with rising asset levels. Smaller funds tended to be more expensive, with lower turnover and less liquidity. Funds that traded less tended to be cheaper, but only when they were larger. The rub, though, is that excessively large funds tended to underperform, implying a limit to how much benefit investors get from economies of scale.
By looking into these characteristics, investors can better evaluate what a given mutual fund is offering. There’s little point in paying a premium fee for a large fund with liquid holdings, after all. A small fund may be worth its price if the manager has requisite skill. Fund characteristics will also change over time. Fees should drop as asset levels climb, for example, but performance could well follow.
More from Chicago Booth Review
We want to demonstrate our commitment to your privacy. Please review Chicago Booth's privacy notice, which provides information explaining how and why we collect particular information when you visit our website.