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How Bloated Is Your Fund?

Sign of the times: Funds are struggling with huge asset bases.

A version of this article was published in the February 2014 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

With a remarkable equity rally behind us, asset bloat is a concern to keep in mind. Although U.S. stock fund flows have been fairly modest overall, some funds have been awash in new money. Which funds face the biggest challenges?

To answer that question, I have dusted off the bloat ratio--a measure I introduced after the great rally in the 1990s. The bloat ratio tries to find out how much a fund trades and how liquid its holdings are. It multiplies turnover by the average day's trading volume of a fund's holdings (asset-weighted). We limited it to U.S. stocks, which in turn limited us to U.S. stock funds.

Thus, a fund with a 100% turnover ratio that owns an average of three days' trading volume figures to be more bloated than one with 10% turnover and stocks averaging three days' trading volume. The trading volume figure is calculated using the amount of shares that trade on a typical day for a stock. So, if stock A trades 1 million shares a day but a fund owns 2 million shares, then we know it owns 2 days' trading volume. In reality it would take many more than two days to trade the stock because placing a massive order out there all at once would move the stock in the wrong direction for the fund.

A Secondary Factor
Bloat is worth considering when you make investments, but don't let it drive the decision you make on a mutual fund. Expense ratios, the record under the current manager, manager investment, and stewardship of the parent company are all more important determinants of a fund's success. Having too much money to run can be a detriment to performance but how much varies significantly. You'll see some successful funds at the top of the bloat ratio list.

How I Tested the Bloat Ratio
As you know, I like to gather data at the beginning of the time period and test how it did over the ensuing time period so I can simulate what an investor could have done in the real world. If you use data today and then look back, you can easily confuse cause and effect. For bloat ratio, I checked pre-expense ratio returns because I don't want something that's simply an indirect way of capturing fees.

I tested the bloat ratio's predictive power for 2002–07 returns and 2007–12 returns. I grouped funds into five groups based on their bloat ratios relative to their peer group. Besides returns I looked at success rate--which measures what percentage of funds survived and outperformed peers. It's a way of incorporating funds that no longer exist. Because many failures get killed off, they can distort the results of these sorts of tests.

Some Predictive Power
The results for bloat ratio were mixed. It worked well for the 2007–12 period but was no help in 2002–07. For the 2002–07 test, the lowest-bloat quintile had a 43% success rate compared with rates ranging from 29% to 51% for the other quintiles. In addition, pre-expense returns of the funds that survived the ensuing period lagged the averages slightly for the lowest-bloat funds and were a bit better for the highest-bloat funds. Likewise, the subsequent Morningstar Rating over the next five years was a bit lower for low bloat than high-bloat funds.

However, in the next five-year period, the bloat ratio performed quite well. The lowest-bloat funds returned 3.6% annualized, a figure that topped all the other groups. In addition, the success rate was 57% while all the other quintiles were in the 30%–40% range. The ensuing five-year star rating was best for low-bloat and worst for high-bloat funds. Why did it work in the more recent period but not the earlier one? I'm not sure. Maybe the safe conclusion is that it's modestly helpful but not strong enough to work over every period. The first time period didn't have a down market and the second one did. Maybe there's some link, but I can't be sure.

Which Funds Have Maximum Flexibility?
Some Morningstar 500 funds have very low bloat ratios. That means they have room to grow.

 Westport (WPFRX) has a Morningstar Analyst Rating of Silver and a bloat ratio of just 0.0037, placing it in the lowest 10% of its category. With a 1% turnover rate and $661 million in assets, it's easy to see why. It's run by the patient Ed Nicklin, who looks for cheap stocks but will keep holding as their multiples grow. Nicklin's emphasis on high-quality names at modest valuations gives the fund an appealing defensive quality.

Vanguard Explorer Value(VEVFX) is a small fund--$284 million with three subadvisors. Its 0.09% bloat ratio is in the lowest third of its category. The subadvisor split means the fund isn't going to have any big positions and thus has the benefit of a lot of flexibility. It also boasts a low 0.60% expense ratio and a 4-star rating. We don't have an Analyst Rating on it. The fund is promising, though its bloat ratio is a bit deceptive as the three subadvisors run similar small-cap strategies on their own. That means they are having a bigger impact on stock prices than would be apparent from this small fund alone.

 FPA Perennial (FPPFX) switched to no-load last year, and it's worth a close look. Its 0.02% bloat ratio ranks in the lowest 26% of the category. This Gold-rated fund has enjoyed strong performance under Eric Ende and Steve Geist, yet the load and a lack of salesforce kept assets at just $322 million. Along with recently added comanager Greg Herr, the managers tend to build positions slowly and thus keep trading costs low. They look for companies with a high return on capital and low debt. That makes this one of the tamer mid-growth funds.

Auxier Focus(AUXFX) is another small, patient fund. The fund's 0.005% bloat ratio is in the large-value category's lowest third. Jeff Auxier employs a Buffett-influenced strategy in which he seeks companies with wide moats and modest prices. He tends to hold a slug of cash for rainy days. Lately the fund has been lagging in the market's rapid ascent, but it's usually a good bet in a downturn.

FAM Value(FAMVX) is another fund that earns its keep in down years. The appeal is that you get near-market returns with below-market risk. The fund lost 8 percentage points less than the S&P 500 in 2008 and 2.5 percentage points less in 2001. The fund's $940 million asset base and single-digit turnover rate give it a bloat ratio of 0.05%, which is small for its peer group.

Which Lack Flexibility?
Many of the funds with the largest bloat ratios are the sort of giants we all know. Funds like  Fidelity Contrafund (FCNTX) and  American Funds Growth Fund of America (AGTHX) have very high bloat ratios--something that's already factored into the Analyst Rating for the funds. Others like the frenetic  CGM Focus (CGMFX) are no surprise, either.

Let's look at a few less obvious funds with high bloat ratios.

 Neuberger Berman Genesis (NBGNX) has very large stakes in rather small names. Thus, the fund's 2.7% bloat ratio is the highest in the mid-growth category. Its turnover rate is just 20%, but its asset size is a massive $14.4 billion. Management has built a strong long-term track record. We rate it Silver because of that record, but it certainly faces a big handicap in managing so much in a focused portfolio of small- and mid-cap names.

 Appleseed (APPLX) is a real surprise. The fund's 63% turnover rate and $305 million asset base don't indicate that there's a bloat issue. Digging down into the portfolio, there's another odd thing. It seems that many of the fund's holdings represent no more than one or two days' trading volume. Yet, the fund owns a massive 31 days' trading volume in  John B Sanfilippo & Son (JBSS), and it also owns a couple of Canadian gold closed-end funds. Sanfilippo is a micro-cap name that would be quite hard for the managers to trade quickly. Much of the rest of the portfolio is quite liquid, as the managers have pointed out in the past. So, in this case I'm not too worried, though I really hope they're right about Sanfilippo.

 Fidelity OTC (FOCPX) and  Fidelity Capital Appreciation (FDCAX) are similar enough to be lumped together. Managers Gavin Baker and Fergus Shiel run these funds in the classic Fidelity style: fast-trading growth funds that aim to always be ahead of the curve. Peter Lynch and Will Danoff showed how great that strategy can work, and scores of other Fidelity managers showed just how hard it is to execute. Baker and Shiel logged great results last year; 2013 was an ideal setting for their strategy.

The high bloat ratio serves to highlight the downside of running a big fund with high turnover, though. Fidelity Capital Appreciation has $8.5 billion in assets and a 156% turnover ratio, while Fidelity OTC has $11 billion and a 116% turnover ratio. That means they are moving a lot of stock around. Normally, I don't worry too much about a large-cap fund with assets around $10 billion, but I do think these funds are not that far from having some capacity challenges. At the moment, neither is seeing big inflows but that certainly could change after their lights-out returns of late. Not only is that a concern on the bloat front, but it also worries me that people would be buying high and possibly setting themselves up to sell low in a correction.

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Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.