Cash DragMutual Funds
Each mutual fund keeps a redemption pool usually ranging from roughly two to five percent of total assets. This pool lets the fund to pay exiting investors without selling investments to meet redemption demands. New investors to the fund refill the pool in the short term. When refilled, fund managers place money into new investments. Unfortunately, these pools also impact performance under certain specific conditions by creating Cash Drag.
After a high performance year, an open end fund may be swamped with large amounts of potential investors. The new entries may attempt to deposit substantially more money than a fund can invest in a short period of time. The manager may be out of opportunities in the short run. They might be forced to invest in opportunities near their peak or select opportunities they would otherwise skip. The alternative is to keep a relatively high percentage of assets in the redemption pool. Redemption pools usually consist of cash and cash equivalents with low return, and slow performance. All of these combined issues create a scenario known as Cash Drag, where cash literally drags down fund performance.
This is another reason it is hard for mutual funds to continuously exceed market performance. Financial pressure created by new investors reduces their ability to perform. Mutual fund managers often cut off new investors after their fund has had a peak year, since they anticipate investments increasing the size of the cash pool beyond what is immediately manageable.
Closed End funds do not suffer these problems, since a static amount shares are already on the market. Open End funds, which could theoretically issue new shares infinitely, are extremely vulnerable to this problem if they are not closed off. A potential conflict of interest can occur. Open end fund managers get paid via annual expenses, which are deducted from the total amount of assets within the fund. Open end fund managers may be tempted to grow fund size to increase their personal paychecks, even if they cannot invest the cash in the short term. They would be ignoring the fact that this hinders performance.
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