Is Your Fund Too Fat?

What is a fund's optimal asset size, and when do assets grow so large that a fund's girth hurts its performance?

Growth in asset level beyond a certain point causes a fund problems because it can raise trading costs or force management to change its investment strategy to accommodate the bigger asset base. In addition, rapid growth can overwhelm management's abilities to find attractive investments. For instance,  Longleaf Partners (LLPFX) closed to new investors this summer to avoid ending up in the situation that  Aegis Value (AVALX) is in, with more than half its portfolio sitting in cash.

I've tried to answer the questions posed above in a couple of ways in the pages of Morningstar FundInvestor. I found that you can get a handle on whether a fund's size is a problem by looking at turnover ratios and the amount of daily trading volume that a fund's portfolio holdings soak up. I also found that it was telling to examine a fund's asset level compared with that of its category rivals.

Those are pretty involved ways of devining when a fund is past its ideal asset level. However, there's another rather simple way to look at it. Ask the fund managers.

Hundreds of fund managers have closed their portfolios to new investment. In fact, about half of the assets in small-cap funds are in closed funds. If asset size weren't a problem, fund managers would never close their funds. After all, if it's not hurting performance, any fund company would rather let one of its funds keep growing and collect the additional fees that would come with running more money. If anything, most fund companies are going to err on the side of managing too much rather than too little because closing funds hurts near-term profitability. (On the other hand, it can be argued that fund closings help long-term profitability because investors judge fund companies by their track record and how much money the funds have made for them.)

Many shareholder-friendly fund companies give a lot of thought to how much money they can manage effectively. Some managers, like John Bogle Jr., set a target closing level even before their funds have launched. You can find some views on the subject at the Web sites of Turner Funds and Dodge & Cox. Naturally, no one has a better handle on a fund's capabilities than management. That doesn't always mean they'll close a fund on time, of course. Until Bob Pozen took over Fidelity, the company steadfastly refused to close funds despite mounting evidence that it was hurting returns.

So, to get an idea of what fund managers think is an optimal size, I looked at the total asset levels at all the closed funds in our database at the time of their closing. I found the figures for 83 funds and grouped them by market cap. For each group, I calculated the median asset size at time of closing to come up with a consensus closing level. In large caps the median was $18 billion, in mid-caps it was $3 billion, and in small it was $800 million.

A Rule of Thumb
These consensus closing levels ought to work as a good rule of thumb when you're considering investing in a fund. If you're looking at a fund with assets above these levels, you should be satisfied that it has greater capacity to handle the money. Look for low turnover because it will make the fund's asset base less taxing on trading costs. Look for a deep bench. Naturally, a company with lots of experienced managers and analysts, such as Wellington or American, is more capable of doing the additional legwork required than, say, a boutique shop with just a couple of investment professionals. You should also make sure you're getting a break on expenses. A large asset base should mean low expenses, which will at least partly compensate for the added problems of running large sums of money.

I should also mention that a new rule will make it easier to find out how big your fund really is. Fund companies often manage money in separate accounts using strategies similar to those employed at their funds. As a result, a fund's asset size actually understates the total amount under management. Soon, fund companies will have to disclose all the assets under management, and investors will have another club in their bag.

Etc.
One of the stranger news items from last week was a report that ING is planning a credit card to be used for loans against your 401(k). I can see the ad now:

Flat-screen plasma TV: $3,000
Vacation in Florida: $1,500
Knowing you've blown your retirement savings and will have to live off Social Security: Priceless.

Who are fund executives rooting for on Election Day? Since they have plenty of shareholders from both parties, most are being quiet about expressing their views. Campaign financing disclosure shows that President Bush is getting the lion's share of donations from fund company execs. About the only fund leader to express his opinion in public, however, is Vanguard founder Jack Bogle. The lifelong Republican told the Philadelphia Inquirer that he's switching sides for this election.