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What's the Right Size for Your Fund?

What fund managers signal about capacity for a strategy.

Russel Kinnel, 09/25/2017

This article was originally published in the August 2017 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

When should a fund close to new investors? How do you know when a fund has outgrown its capacity?

It's one of the trickier things to figure out from the outside. I've written in the past about the bloat ratio, in which I use turnover and the average daily trading volume of a fund's portfolio to understand which funds are being affected by asset bloat and which may have grown too large.

But you can also come at the problem from an altogether different angle. You can let portfolio managers tell you the appropriate size by looking at the records on fund closings. After all, they know their strategies well and have strong incentives not to close to new investors too soon as that would mean forgoing revenues.

Today, many small- and mid-cap managers have set a strategy's targeted assets under management from day one. They know what kind of market-cap expo­sure, turnover, and concentration they want to have in the fund, and that implies a certain level of capacity.

To be sure, there are still some "I know it when I see it" managers who simply aim to close when it becomes a problem. But once it's a problem, how does one dial it back to the optimal level? Also, the fund may well get additional money, as closing typically permits existing shareholders to make more contributions. In short, you have to get ahead of the problem.

Fund managers and fund companies that think long term have strong incentives to avoid a performance slump caused by asset bloat. To be sure, some fund managers and companies are much more inclined to go for the quick payoff and let a fund get too big.

In the short run, closing does reduce profits, but in the long run, doing everything to improve the chances for sustained outperformance pays off.

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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