Open-ended mutual funds have a great track record of growing to mammoth sizes quickly as investors flock to them. But it is possible for a fund to get so large that size gets in the way of performance. It’s best to know how to determine whether a fund is too large (or too small) for you and whether it’s still a good fit for your investing strategy.
How Do Mutual Funds Grow?
Open-ended mutual funds have just two ways to grow in asset size:
- Strong performance by the stocks and other investments in the fund’s portfolio. When the underlying assets in a portfolio increase in value, the fund’s asset size increases.
- The inflow of investor money. A fund’s asset size can continue to grow even if it has a negative return if new investors keep pouring in money.
Of course, one leads to another. A strong performance by a fund for a quarter or a year inevitably brings in new customers.
When Size Hinders Fund Performance
As more investors move into a mutual fund, the fund manager is presented with a significantly bigger amount of cash. There’s pressure to put that cash to work as soon as possible. The risk is that a manager’s next choices may not be optimal for the fund’s investors.
There’s no formula for determining the point at which fund size will begin to hinder performance. The outcome is clear, though: When the fund manager is unable to maintain the fund’s investment strategy and therefore cannot produce returns comparable to its historical record, the fund has become too large.
When Fund Size Does and Doesn’t Matter
Size is not a problem for index funds and bond funds. In fact, bigger is definitely better for both. Portfolio management is practically on auto-pilot, so investment missteps are minimized. And, more investors mean that the fund’s operating expenses are spread over a larger asset base, thus reducing its expense ratio.
In the mutual fund industry, a fund’s size must be looked at in the context of its investment style. Some funds suffer when the fund outgrows its investment style.
For example, a small-cap growth fund that grows in asset size from $100 million to $1 billion simply can’t be as effective in following its initial strategy. Most small-cap fund managers have a stock-picker mentality, which is what attracts certain investors in the first place. These funds concentrate their assets on a relatively small number of thinly traded stocks. If the fund attracts too much money, the fund manager may have trouble purchasing additional large blocks of thinly traded shares without driving up their prices by doing so. Performance may slip as the fund manager struggles to find new stock picks.
Managing Fund Size Difficulties
When a fund’s size compromises management’s ability to maintain its investment approach, the mutual fund manager has three choices:
- Continue to manage the larger fund with the same strategy that was effective when the fund was half the size.
- Change the fund’s investment approach, which may undermine the confidence of the investors who bought into the fund because of its stated investment strategy.
- Close the fund to new investors.
When Large Equity Funds Become Generic
Funds that are very large tend to become what the industry calls “closet index funds.” In other words, their portfolios begin to resemble an index fund (except the fees are larger).
As assets grow, mutual fund managers need to spread the money over a larger number of stocks because investing large amounts in a few stocks can affect their share prices.
As a result, the individual investor pays extra fees for active management but gets a performance similar to that of an S&P 500 index fund.
Best and Worst of Small Funds
Small funds can be nimbler. A small mutual fund might invest $1 million in a stock, while a large one might invest $30 million. As you can imagine, it’s much easier to get out of (or into) a stock with $1 million than with $30 million. Selling a large amount of stock can take several days, and even then then its selling would put downward pressure on the stock’s price, reducing the fund’s return on investment.
Smaller funds also have shortcomings. A new smaller fund can exhibit excellent short-term performance, which can be misleading because a few successful stocks can have a big impact on the fund’s performance. Investors can avoid that trap by checking the fund’s track record over a few years, not a quarter or two.
Secondly, because smaller funds are less diversified, a poor performance by one stock will have a big negative impact on the overall portfolio.
Finally, operating expenses tend to be higher for smaller funds because of the lack of economies of scale.
Big Isn’t Always Bad
For some segments, market size really doesn’t matter. 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 bond prices are less sensitive to high-volume trades. As a result, bond fund managers oversee assets with higher liquidity.
Not all large funds are notorious underperformers. For example, some investors were wary when the Fidelity Magellan Fund surpassed $1 billion in assets in the 1980s. The fund then rose to $13 billion in less than seven years, due to a combination of money inflow and fund manager Peter Lynch’s superior stock-picking talents. Under his management, the Magellan Fund outperformed the S&P 500 index in 11 of the years between 1977 and 1990 and had an average annual return of 29%.
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 its era. In the years following Lynch’s managerial leadership, the Magellan Fund continued to grow, passing $100 billion in 1999.
While the fund’s size had fallen to $21 billion by 2020, the average annual total return over the life of the fund was still exceptional at 16% as of 2020.
Finding the ‘Just Right’ Funds
Just as Goldilocks found the bowl of porridge that was “not too hot and not too cold, but just right,” you can find a fund that is just right. The following general rules may help you determine whether a mutual fund’s size is a hindrance or a benefit to its 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.
- Avoid Funds iwith a Shrinking Asset Base. 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, either because investors are withdrawing or the portfolio is underperforming.
- 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 amount of cash to satisfy investor withdrawals, a fund with more than 15% in cash may indicate that the manager is having difficulty allocating the assets. There are exceptions to this rule, as some fund managers stash cash so that they can be ready to pick up bargains after a downturn.
The Bottom Line
Mutual funds grow, and their growth may affect their performance. It is possible for a fund to grow so large that it’s unwieldy.
It’s up to you to make sure to pick a fund with a strategy that matches your goals. If it becomes too big or too small to keep up its past performance, it could be time to bail out.