Open-ended mutual funds have a great track record of expanding to mammoth sizes quickly as investors flock to these growing funds. But it is possible for funds to get too large and cause problems for fund managers and investors. In this article we'll show you how to handle the rapid growth of these funds and how to determine whether these funds are a good fit for your investing strategy.

How Do Mutual Funds Grow?
When we talk about size, we are referring to the total asset base or total amount of money that a mutual fund manager must oversee and invest.

Open-ended mutual funds grow their asset size in two ways:

  • Strong performance of stocks and/or bonds in the fund's portfolio. When the underlying assets in a portfolio increase in value, the fund's asset size increases.
  • The inflow of investors' money. This is why a fund's asset size will continue to grow even if it has a negative return.

When Size Begins to Hinder Performance
As more and more investors are attracted to a specific mutual fund, the manager is presented with a significantly large amount of cash. The risk that arises in this situation is that to put the cash to work as soon as possible, some managers may purchase additional instruments that are not optimal for the fund's investors.

To determine when size begins to hinder performance, we need to ask at what point the positive relationship between fund size and management efficiency becomes negative - that is, the point at which the negative effects of a fund's size cancels out the positive effects of a fund's total return performance. It is difficult to determine exactly at what point this occurs; but in general, when the fund manager is unable to maintain the fund's investment strategy and produce returns comparable to the fund's historical record, the fund has become too large.

It should be noted that with index funds and bond funds, size is not a problem. In both these cases, bigger is definitely better. Portfolio management is easily handled and the funds' operating expenses are spread over a larger asset base, thus reducing a fund's expense ratio.

In the mutual fund industry, a fund's size must be looked at in relation to the context of its investment style. Some funds suffer when the fund outgrows its investment style. For example, a small cap growth fund in which asset size grows from $100 million to $1 billion is simply not as effective in its initial strategy. Most small cap fund managers have more of a "stock-picker" mentality, which may be what attracts certain investors to this kind of fund in the first place. Small cap funds usually have stock that is thinly traded and tend to concentrate on a smaller number of stocks. If the small cap manager is successful and the fund attracts new investors (and money), the fund manager may have trouble purchasing additional large blocks of the thinly traded shares without driving up the share price and making it more expensive. Performance may slip as the fund manager attempts to find new investments with the new influx of cash.

Combating Fund Size Difficulties
When a fund's size compromises management's ability to maintain the same investment approach, the mutual fund has three choices:

  1. Continue to manage the larger fund with the same strategy that was effective when the fund was half the size.
  2. Change the fund's investment approach, which may undermine the motivation of the investors who bought into the fund because of its stated investment strategy.
  3. Close the fund to new investors.
  4. Convert the open-end fund into a closed-end fund. In this way, the fund will no longer increase as a result of investors making additional cash payments into it.

When Large Equity Funds Become Generic
Another problem large funds encounter is that because they are more difficult to actively manage, they tend to become what the industry calls "closet index funds." In other words, their portfolios begin to resemble an index fund. As assets become larger, mutual fund managers need to spread the assets over a larger number of stocks because investing large amounts in one particular stock, as we mentioned earlier, may affect the share price. As a result, the individual investor, while paying extra fees for "active" management, ends up receiving a performance similar to that of the S&P 500 index.

So is Smaller Better?
Some investment managers prefer a smaller fund because it allows them to move quickly in and out of stocks. Compare, for example, a small mutual fund that might invest $1 million in a stock to a large one that might invest $30 million. As you can imagine, it's much easier to try to get out of (or into) a stock with $1 million than with $30 million. Selling $30 million in stock could take several days, and the selling would put downward pressure on the stock's price.

At the same time, smaller funds can also be too small. First of all, new smaller funds can exhibit excellent short-term performance, which can be misleading because a few successful stocks in the portfolio could have a large impact on the fund's performance. Because these new funds do not have as long of a track record, some investors could be enticed to purchase a fund managed by an inexperienced manager. Secondly, because funds are less diversified, the poor performance of one stock will have a large negative impact on the overall portfolio. Lastly, operating expenses tend to be higher for smaller funds because of the lower opportunity to take advantage of economies of scale.

Not All Large Funds are Bad
For some segments, market size simply doesn't matter. For example, a fixed-income (bond) fund should produce consistent returns, regardless of its size. The market for bonds is far larger than the stock market, so price is less sensitive to high-volume trades. As a result, bond fund managers oversee assets with higher liquidity.

In addition, not all large funds are notorious for underperforming. For example, people began to criticize Peter Lynch in the early 1980s when his Fidelity Magellan Fund surpassed $1 billion in assets. The fund, however, rose to $13 billion in less than seven years - this increase in assets came from the performance of the underlying assets and the large inflow of funds attracted by Peter Lynch's superior stock-picking talents. Under his management, the Magellan Fund outperformed the S&P 500 index by 13% per year from 1977 to 1990. Had you, as an investor, passed on it once it reached $13 billion, you would have missed out on one of the great investment opportunities of recent time. In the years following Lynch's managerial leadership, the Magellan Fund continued to grow, reaching $137 billion in 1999. While the fund's size decreased to $13 billion in 2013, the average annual total returns over the life of the fund is still exceptional at 16.33% as of 2013.

Finding the Funds that are 'Just Right'
Just as Goldilocks found the bowl of porridge that was "not too hot and not too cold, but just right," you too can find a fund that is not too small or too big, but just right. The following general rules may help you determine whether a mutual fund's size is a hindrance or benefit to the fund's returns:

  • Consider the Size in Relation to the Investment Approach. While Peter Lynch may have been able to handle the size of his blend fund, you can bet that a small-cap growth fund with an asset value of $1 billion wouldn't fare as well.
  • Funds in Which Asset Base is Shrinking Should Raise a Red Flag. Be sure to review and compare past cash holdings of the fund you are considering. A shrinking asset base means the fund is losing money because investors are withdrawing their investments, or the performance of the assets in the portfolio have greatly depreciated in value.
  • Beware of Funds with Large Cash Holdings. Compare the fund's total cash holdings in the current year to its holdings in previous years. Although mutual funds are required to maintain a small portion of the portfolio in cash to satisfy any investor requests for redemption, a fund with a large portion of its portfolio in cash (greater than 15%) can indicate that the manager is having difficulty allocating the fund's assets to various securities. There are exceptions to this rule, as some fund managers habitually use large cash holdings to anticipate a market decline, thereby having the cash ready to quickly pick up bargain investments.

The Bottom Line
Mutual funds grow, and their growth may affect their performance, so it's up to you to make sure their strategies match their goals, or take your money elsewhere. To have a large growth fund that you are truly happy about is one thing - to stick with it because you don't know better is another.

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