Daily Liquidity Hurts Mutual Fund Investors
We all know the number one rule in investing is liquidity. However, there is liquidity for liquidation purposes and then there is liquidity for trading purposes. A lot of times, we come across articles stating that "if a fund does not give daily liquidity you should not invest in it." Often this argument is put forth to an investor by a broker in order to help convince the investor to overlook other alternative asset classes for the more liquid mutual funds. On the surface, this does in fact appear to be rational advice, however, when you dig deeper this advice is not exactly correct.
First and foremost, if an investor is investing in a fund for a lengthy period of time, they should not be overly concerned if they do not have daily liquidity. They should be concerned if the assets held in the fund have the required liquidity, even if the fund itself does not. It is often better if the fund itself does not, and in all honesty, should not have daily liquidity.
If your fund has daily liquidity, your fund is subject to day trading investors. By day trading investors, we mean investors that buy the fund and then sell it for one reason or another a very short time later. You might say "so what, as long as I stay invested, I could care less what someone else does." Unfortunately, your future retirement requirements do not afford to let you have this attitude.
When you buy or sell a mutual fund, you do it on the closing price or NAV of the fund. This price is the same for all buyers and all sellers on any particular day. This buying and selling has a measurable trading cost to you. Every time an investor buys or sells a fund, the fund manager has to go out and buy or sell stock that the fund holds. Obviously, when doing so, the fund manager has to pay brokerage on the transactions. However, since the investor buys or sells at the closing price of the fund, all the trading brokerage costs are paid for by all the investors in the fund. Basically, long-term holders of a fund are paying the transaction commissions for the short-term traders.
If the fund were to publish average daily transaction costs or the average investor holding period or the fund's asset turnover period you could estimate how much these day traders are costing you. Unfortunately, so far the SEC has not changed policies requiring mutual funds to post any such numbers. However, the SEC not changing mutual fund policy does not diminish the size of these costs.
A recent article written by Roger Edelen, Richard Evans and Gregory Kadlec in the Financial Analysts Journal1 goes about trying to estimate these transaction costs brought about by day traders. Edelen, Evans and Kadlec looked at 1,758 U.S. mutual funds and made some startling observations. Edelen, Evans and Kadlec calculated that the average mutual fund pays a staggering 1.44% per year in transaction costs. The transaction costs for the average growth fund being higher at 3.17% per year while for the average large cap fund it is 0.84% per year. These calculated estimates are larger than what most investors pay in management fees and clearly point out a problem with having too much liquidity.
One must realize that although liquidity is important, having too much of a good thing is not always better. Fund investment strategies take time to play out. Investing in a fund that only allows monthly liquidity, helps prevent the investor from paying for short-term trading transaction costs and helps them along the way to their retirement needs.
1) Trading Costs on "Invisible" Costs: Trading Costs and Mutual Fund Performance, Financial Analysts Journal, January / February 2013, Volume 69, No. 1, Roger Edelen, Richard Evans, Gregory Kadlec.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.