More Mutual Funds Threatened by Asset Bloat

One of the key challenges for fund investors and fund companies alike is asset growth in mutual funds, although it seems strange to say that with a bear market and the mutual fund timing scandal in the not-too-distant past.

Yet, those problems led investors to focus on a fairly small list of firms that avoided scandal and limited the downside during the bear market. In addition, a six-year-long small-cap rally inspired investors to plow more money into funds that are most sensitive to asset growth. (Small caps are much less liquid, so asset growth can mean that a fund has to move up the market-cap ladder, expand the number of holdings, or accept higher trading costs due to increased market impact.)

How big a problem has asset growth become? To get an idea, I looked at the growth in funds with assets over $1 billion. From the end of 2000 to today, the number of $1 billion-plus funds has grown from 730 to 1,123. (For this count, I excluded multiple share classes so that a fund with A, B, C, and D shares would only count once.) Among small-cap funds, the figure has grown from 36 to 81. If you thought you were the only one having a hard time finding a good small-cap fund, foreign or domestic, that was still open and not too bloated from assets, think again.

Things To Consider
One way to get a handle on whether a fund has grown too large is to let fund managers' own decisions guide you. A while back, I looked at the median point at which small-, mid-, and large-cap funds closed to new investors. After all, fund managers should have a good handle on their funds' capacity limits. That breakdown works like this: small-cap funds, $800 million; mid-caps, $3 billion; and large-caps, $18 billion.

Using that as a starting point, you should consider a few additional factors to determine if you should ratchet up or down those figures.

1. How high is turnover? A fast trading strategy requires a tight lid on assets because it places a tremendous premium on liquidity. So, a high-turnover fund with assets over those midpoint closing levels would be a worry, whereas you could ratchet up the acceptable asset level for a low-turnover fund.
2. How deep is the research team? A fund manager only has so much time to research stocks. Thus, asset bloat can be a real problem for fund managers who have limited analyst support. On the other hand, those with broad analyst support, such as Dodge & Cox or American, are better able to handle growth.
3. How much does the manager run in other accounts? You might think that a manager is faithful to you and your fellow shareholders and would never think of running money for anyone else, but you'd probably be wrong. Most fund managers run either separate accounts or other mutual funds. You should factor those in when assessing asset size.
4. How much does the firm run in similar strategies? If a fund's stock picks are driven by analysts who are shared firmwide, then it's important to know which of the firm's other funds are likely trading based on the same recommendations. At big fund companies, you may have a lot of fund managers trying to squeeze through the same door at the same time.

In sum, seeing how a fund stacks up on these counts can help you to figure out if you're getting a has-been or a fund with potential.

Update
Last week I asked what fund is the best bet to rebound. Most of you (55%) believe it is  Vanguard U.S. Growth (VWUSX).  Fidelity High Income (SPHIX) got 22% of your votes, while  Putnam New Opportunities (PNOPX) received 14%.  American Century Giftrust (TWGTX) came in last with 9%.