When Funds Get Too Big

Russel Kinnel: Hi, I'm Russ Kinnel, director of fund research for Morningstar. I'm joined today by David Kovacs, chief investment officer of quantitative strategies at Turner Investment Partners.

David has worked on capacity estimate for Turner, and what that means is they try to estimate how much money they can run in funds. A number of fund companies do this internally, but Turner is maybe the only one I know of that not only publishes that, but even publishes a white paper explaining how they came to that capacity estimate.

David, why don't we start with just what's the point of doing a capacity estimate? What are the bad things that happen if a fund gets too big?

David Kovacs: Sure. The idea is that there is a certain level at which a fund may reach a certain level of assets where it can no longer execute its investment strategy with the same efficiency as it can with a smaller level of assets.

Therefore, it's worthwhile to calculate at what level these funds should close, so that the manager has the potential to maintain his or her potential for excess returns.

Kinnel: If the fund gets too big, it's running the risk of things like trading costs ballooning, asset size getting too big, and the strategy really can just fall apart.

Kovacs: Correct. So what happens is if the asset level gets to be too large for the investment strategy, it may take too many days to either build positions, or too many days to eliminate positions, selling those from the portfolios.

And because you may take longer than ideally that manager would prefer to either buy or eliminate the positions, there is an adverse effect of the price getting too high as the manager buys the stock, or the price getting too low as the manager sells the stock.

So therefore, as the asset size grows to a certain level, the manager is no longer able to buy or sell positions in an appropriate time frame, and as a result of that, performance may lag and sometimes significantly for a long period of time.

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Kinnel: Your study suggests that obviously investors should be more wary based on smaller market caps, that your capacity estimates for, say, your micro cap and your smaller cap strategies are much smaller than large cap. Can you walk us through that?

Kovacs: Sure. Capacity is a function of the liquidity that's available for stocks, namely how many shares trade at what price over time. Typically, in most cases, smaller companies are less liquid than large companies. Therefore, micro cap stocks for example, or micro cap funds, should close much sooner than, let's say, mid cap or large cap funds.

Our calculation for the Turner Micro Cap Growth Fund, for example, is that we can manage up to about $800 million altogether in that asset class, where a large cap manager at Turner may manage up to $20 billion and there's still capacity left.

Therefore, the micro cap managers, the retail investors who buy these funds, they should be aware of the size of the funds before the purchase. Micro cap funds typically should be below $1 billion, small cap funds altogether should be roughly in the range of $2 billion and not more. But the mid and large cap funds can run into the tens of billions.

Kinnel: You've also found that value is a strategy that has greater capacity than growth, why is that?

Kovacs: That's correct. That's an interesting observation. Value managers typically buy stocks as others may sell them. They may be able to build positions over time, because they don't buy on specific news, whereby it's timely to immediately invest in the stock or potentially sell the stocks on bad news.

The value managers may have the luxury of building the positions over a longer period of time, and also selling those positions over a longer period of time as the stocks have reached their price targets.

So, by definition, since value managers have longer periods to either invest or sell out of positions, their capacity may be significantly larger than those growth managers who have to buy and sell on a timely basis, and have maybe two or three days to either build or eliminate positions.

Kinnel: OK. David, thanks so much.

Kovacs: Sure. Thank you for having me.