Is Your Fund Too Fat?
In 1993, the $61 million Baron Asset Fund was one of the hottest undiscovered funds around. Portfolio manager Ronald Baron zoomed in on small companies and, to maximize the impact of his savvy stockpicking, kept the portfolio down to 30 stocks. Result: returns that handily beat the Standard & Poor's 500-stock index and Baron's peer group of small-cap funds.
Then a torrent of cash poured in. By last year, Baron Asset had ballooned to $6.1 billion. The portfolio grew to about 50 stocks, more of them mid-cap than small-cap. And Baron's returns dwindled. The fund no longer makes it even into the top 25% of its peer group.
In short, Baron Asset is a poster child for how success can backfire on mutual funds and their shareholders. "Fund size is much more of an issue than fund companies would admit," says Tricia Rothschild, an analyst at fund tracker Morningstar. Baron begs to differ. His fund's size, he says, "has not had much of an impact at all." Instead, the market's infatuation with technology stocks has punished the fund, which does not concentrate on that sector.
Perhaps. Still, fund investors have long suspected that unchecked asset growth can cut into returns. Fund analysts and even some managers are now trying to come up with ways to decide just how large a fund can get without losing its edge. In a time of record inflows to equity funds, investors need to be as careful about fund size as they are about performance and expenses.
Big isn't always bad. Index funds, money market funds, and many bond funds can improve when they bulk up, because what differentiates one from another is expenses, and larger asset bases help contain costs. The expense ratio for Baron Asset has fallen from 1.8% to 1.3% since 1993, but what shareholders have saved has been lost to poor performance.
Size is a top concern for actively managed stock funds, particularly growth funds. Sure, some gargantuan growth funds, such as Janus 20, have been standouts. But they're the exception rather than the rule, according to a Morningstar study. It shows that risk-adjusted returns for small- and mid-cap growth funds start to decline at $150 million. Large-cap growth funds can continue to do well until they reach about $4 billion, while value funds "can get somewhat larger before experiencing problems," says John Bogle Jr., president of Bogle Investment Management in Wellesley, Mass.
Why is there a difference between growth and value? Growth funds tend to buy stocks on good news, such as knockout earnings reports. But because that's when everyone wants in, it's harder to purchase the bigger block of stock a large fund needs without pushing the price sharply higher. And when bad news prompts investors to bail out, a big fund trying to sell a large position in a hurry will be forced to take a lower price.
Value funds, on the other hand, are contrarian and buy stocks that no one else wants. That gives them time to build positions, which means their purchases have less of an impact on prices. The same is true of their sales, which typically occur when a stock is back in demand.
HIDDEN DEBIT. "Market impact" costs are not listed on shareholder statements. Instead, they eat away at returns. Bogle calculates that funds with as little as $300 million in assets lose an average of 0.25% of the total dollar value of each trade, while bigger funds lose more. Since the average fund turns over 92% of its holdings a year--a $1 billion fund does trading worth $920 million--that adds up.
Some funds are addressing the size problem by closing to new investors. Others are buying stocks with larger market capitalizations. For example, a small-cap fund might start dabbling in mid-caps. That can be a problem for investors who are trying to adhere to an asset-allocation plan that calls for a small-cap fund.
Fortunately, investors can take steps to combat fund bloat. One way is to invest with companies that have shut funds to new investors in the past, such as AIM, American Century, Franklin, and Vanguard. Closing just slows the inflows since existing shareholders can continue to invest. A few fund sponsors, including Bogle, Turner Investment Partners, and newcomer Undiscovered Managers, go a step further by committing to close funds at preset asset levels.
Don't count on closings, though. Because most managers are paid a percentage of the assets they manage, they have an incentive to increase inflows, says Josh Weiss, senior analyst at No Load Fund Analyst. Indeed, only 148, or 2.6%, of all funds are currently closed to new investors.
Another approach is to buy new funds run by managers who have proven themselves elsewhere. Examples include Bogle Small Cap Growth, Artisan Mid-Cap, Ranier Core Equity, and Undiscovered Managers' Small-Cap Value and Special Small-Cap funds. Before diving in, though, find out if the manager also runs institutional accounts in the same style. If so, you have to count those assets, too. And because trading costs are at the root of the size problem, it helps to find funds with low portfolio turnover.
Once you own funds, it's as important to monitor asset growth as it is to watch performance. And don't hesitate to dump behemoths, says Ronald Roge, a financial adviser in Bohemia, N.Y. Because growth undermines performance as well as shareholders' asset-allocation plans, it can cost more to keep a fat fund than to sell it and incur a tax bill.
One sign that a fund may be too big is when it owns more shares of a stock than trade on an average day. That's the case with Baron Asset, which owns 20.1 million shares of auction house Sotheby's. Since only about 92,100 shares change hands daily, the fund would theoretically need 218 days to unload its position.
If you're not afraid of crunching numbers, you can get a better idea of how much money your funds can handle. David Kovacs, a senior portfolio manager at Turner Investment Partners in Berwyn, Pa., has developed a formula that tells Turner when to close its funds (table). Among the factors he considers are the number of stocks in a portfolio and how easy they are to trade. Still, size targets can change with the market. For example, if investors become cautious and move to the sidelines, market liquidity falls--and so does a fund's size limit.
Calculating a fund's ideal size is an inexact science. You could end up selling a winner while it's still on a roll. But evidence shows that fat assets weigh down fund returns--and you want to get out before that happens.