Wednesday, July 16, 2008

Are high mutual fund minimums good?

High mutual fund minimums can be a good thing. The mass affluent segment should investigate funds with higher minimums. Here's a story that gives reasons why (free WSJ Digg link).

But there are reasons for considering paying up. Of course, by raising minimums some funds are being picky about who they let in the front door. But in some cases, they also are trying to control costs and protect shareholders. The fewer shareholders a fund has to deal with, the less it has to spend on annual reports or account maintenance. That can translate into lower annual fees. High minimums can also cool off asset inflows into a hot fund.
Once I'm invested in a good fund, I want the fund to restrict who else can invest. Basically, I want the manager to only have enough money that he or she can invest well. If the fund gets hot, and new money pours in, the manager has to start investing in worse and worse ideas that are going to lower overall returns.

Let me give a simple, canned example. Let's say I have $10,000 in a fund that owns a single stock that returns 20% a year. Therefore, leaving out fund fees for simplification, the fund returns 20% to me a year. Now the fund let's in another investor who invests $10,000. The fund manager invests the new money in a stock that returns 10% a year. Now since I own 1/2 the fund, and the new investor owns the other 1/2, I essentially have $5,000 invested in a stock that returns 20% a year, and $5,000 invested in a stock that returns 10% a year. This has put me in a worst position than when I was the sole investor in the fund.

Discouraging frequent redemptions is another feature I look for in my mutual funds. Frequent redemptions by other shareholders causes either the fund manager to keep cash on hand instead of investing it, or to sell investments to raise cash, potentially selling investments that still have room to run.