The Fund Funnel

here are a lot of mutual funds. At least, there are a lot of funds that enter the fund funnel. The number of funds that emerge out of the fund funnel can be surprisingly small.

As of August 31, 2003 there were 15,303 mutual funds in Morningstar's Principia software after subtracting 38 Objectives, 60 Categories and 132 Indexes. Of the 15,303 funds there were 8,733 U.S. equity funds, 1,969 non-U.S. equity funds, 2,662 taxable bond funds, and 1,939 municipal bond funds.

Let's focus on U.S. equity funds. One would assume that with 8,733 U.S. equity funds the choices would seemingly be endless and that the task of choosing a fund would be daunting. In fact, the purchase-able universe of funds that have a reasonably long performance history is unexpectedly small in some cases.

The universe of 8,733 U.S. equity funds was reduced to 1,228 funds when removing portfolios with less than a 10 year performance history (as of August 31, 2003). In other words, 86% of all U.S. equity funds (as of 8/31/03) had an inception date after August, 1993. This particular funnel "filter" was imposed to isolate funds with a history long enough to include both good and bad years in the U.S. equity market.

Of the 1,228 funds, 604 were no-loads and 624 were load funds. A load fund in the Principia database is a fund that either has a front load, a back-end load, or a 12b-1 fee in excess of .25%. After removing funds that had purchase constraints (e.g. closed, institutional, or qualified access) there remained 344 no-load funds and 585 load funds. This set of 929 funds can be thought of as generally available funds.

The next filter removed "redundant" portfolios. When a mutual fund is distributed via several different share classes it creates a distortion in the number of funds because the same portfolio is counted multiple times. To prevent this type of distortion it is important to remove redundant portfolios. The remaining portfolios are referred to as "distinct" funds. Inasmuch as this is an issue that almost exclusively impacts load funds the number of no-load funds remained at 344, but the number of load funds was reduced to 475.

Thus, from a starting point of 8,733 U.S. equity funds the number of distinct, generally available funds with at least a 10 year performance history was winnowed to 819 - a reduction of over 90%. Less than 10% of the universe of U.S. equity funds remained after applying three basic filters.

Several descriptive statistics of the funds that made it through the funnel are reported in Figure 1. The survivors were primarily large cap funds. Among no-loads 63% were large cap funds and among load funds 68% were large caps. About 60% of the 8,733 U.S. equity funds in the aggregate fund universe are classified as large cap funds. The slightly higher percentage of large cap funds among those that passed through the funnel is not surprising given the requirement of a ten year performance history.

It is startling to see a total of only 17 small cap value funds in Figure 1. When we speak of thousands of available mutual funds we evidently are not referring to the small cap value category. Indeed, even before applying the filters, small cap value funds only represented 2.3% of all U.S. equity funds, which is only a slightly higher percentage than what is represented by the 17 survivors in Figure 1.

The average annual expense ratio among the 344 surviving no-load funds was 1.09%, substantially lower than the 1.40% average among the 475 load funds. The "party line" that load funds offset the load with lower expense ratios is difficult to document. Manager tenure among no-loads averaged nearly 3 years longer than among load funds. Turnover ratio among no-load funds was about 20% lower than among load funds. No-load funds had markedly higher returns, on average, compared to load funds over the prior 3, 5, and 10 year periods. Return figures for load funds were load-adjusted. Standard deviation of return and tax-efficiency (now referred to as Tax Cost Ratio by Morningstar) was consistently, though only marginally, lower among no-load funds. Finally, the average Bear Market Rank (where a lower score is better) slightly favored no-load funds.

The final filter in the fund funnel was expense ratio (see Figure 2). The cutoff for no-load funds was 1.09%, which was the average expense ratio for the 344 no-load funds as reported in Figure 1. For load funds, the expense ratio cutoff was 1.40%. The number of surviving funds was reduced from 819 to 482. (The astute reader will perceive that 482 is not half of 819, which if using a mean figure as the cutoff point should render very near half of the sample. That is true only if data are normally distributed, which is not the case with expense ratios). So, from a starting universe of 8,773 funds a final group of 482 funds remain. They represent distinct, purchase-able U.S. equity funds with at least a 10 year history and which have a lower than average expense ratio.

Large cap portfolios continue to be predominant among load and no-load funds. Thus, despite the winnowing effect of the funnel, there is ample choice if shopping for a large cap fund. However, if looking for a mid cap or small cap fund the filters in the fund funnel had a much more profound impact. Among no-loads, only 27 funds remained in the entire mid-cap category and just 19 in the small cap category. Among load funds, the number of choices among mid-caps is a bit broader, particularly in midcap growth. Small cap load funds are scarcer still, with only 14 making it through the four filter funnel.

With respect to performance comparisons, in six of the nine style boxes, no-load funds outperformed their load fund counterparts over a 10 year period. However, where the number of funds is small, performance comparisons are less valid.

In summary, the universe of U.S. equity funds does indeed seem large. And that can be a problem inasmuch as too many choices can be very bewildering (e.g. trying to decide which camera to purchase). This research suggests that by applying several fundamental filters the relevant set of funds can be quickly reduced to a more manageable set. Doing so may minimize "paralysis by analysis", or the problem of attempting to process too much information before taking action. Let the filtering power of a fund funnel work for you and your clients.

Figure 1. 819 "Fund Funnel" Survivors

(Distinct, purchase-able, U.S. Equity Funds with at least 10 years of performance history)

                    344                                        475   

Large Cap Value                               59                                   108             

Large Cap Blend                               96                                   110             

Large Cap Growth                                     63                                   104

Mid Cap Value                               18                                   22

Mid Cap Blend                               23                                   22

Mid Cap Growth                                     32                                   65

Small Cap Value                               11                                   6

Small Cap Blend                               23                                   12

Average Expense Ratio (%)                1.09                               1.40                    

Average Manager Tenure  (yrs)            6.9                                  4.0              

Average Turnover Ratio (%)               72.6                                89.4

Average Load-Adjusted Return (%)

          3 Year                                                -5.8                                -10.1

5 Year                                                5.9                                  3.5

10 Year                                 9.0                                  7.6    

Average Standard Dev. Of Return (%)

          3 Year                                                17.7                                18.2

          5 Year                                                20.8                                21.8  

          10 Year                                 18.5                                19.3

Average Tax Cost Ratio (lower ratios indicate greater tax efficiency)

          3 Year                                                1.19                                1.21            

          5 Year                                                1.48                                1.54

          10 Year                                 1.87                                1.95

Average Bear Market Rank (%)               47.6                                50.8

Figure 2. 482 Low Cost Funds

Funds with an Expense Ratio lower than the average