Mutual funds face problems

It can seem reassuring if an actively managed mutual fund that you're considering is massive — meaning that many investors have trusted lots of money to it. But managers of big funds face challenges.

As fund managers become more successful, delivering strong returns for their shareholders, more dollars will likely come their way. They'll collect more in fees, but they'll also have to find additional promising investments for that money. Ideally, they will invest in the best, most lucrative securities they can find. But they can't always put as much as they want into any one stock.

Most funds managers want their funds to be classified as “diversified,” so they're required by law to have at least 75% of fund assets invested in no more than 5% of any particular issuer's securities. Even if they're extremely bullish on, say, six different stocks and want to invest 10% of fund assets in each, they can't. For better or worse, they can't make huge bets on any particular stocks. Therefore, they end up investing in their best ideas, and their next best ideas, and plenty of securities that are far from the top of their list.

The Fidelity Contrafund, for example, had spread its assets across 344 different securities as of late March. In late April, it had nearly $1 billion invested in Home Depot stock, but that made up only 0.854% of fund assets. Only 18 holdings made up more than 1% of assets.

How has Fidelity's Contrafund performed? Well, on an after-tax basis, it has lagged its benchmark index over the past three, five and 10 years — so investors would have been better off with a low-fee S&P 500 index fund.

Go ahead and consider large (and smaller) actively managed mutual funds, but research them well before buying. Consider not only their performance over many years, but also fees and factors such as their managers' tenure.

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