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How Bigger Can Be Better

Yes, Fidelity is the source, but it's true.

Small Isn't Always Beautiful Most mutual fund observers believe that size hurts. As funds (and fund companies) grow larger, they become cumbersome. Their assets outstrip their best ideas, forcing them either to dilute their portfolios by moving down their buy lists or to hike their trading costs by pumping too much money into their favorite securities. Thus come the debates about when to close funds that have become too large, and the barbs directed at "greedy" fund companies that keep their doors open.

Most fund observers are probably right. Last year, three professors found that new, small mutual funds tended to outperform their older, larger peers. The professors argued that those results are primarily because younger managers are more skilled (having more recently attended business school, learning the latest tricks), but they acknowledged that immobility was also a factor. Clearly, funds that invest in niche, illiquid markets and that trade frequently will quickly struggle with incoming assets. So, too, will many funds that hold concentrated portfolios.

But there is another side to the size story. Funds that feed in big, highly liquid markets and which follow buy-and-hold strategies may benefit from heft. A giant asset base gives them giant revenue streams, which may be used to staff large research teams, hire expensive talent, and receive [glances furtively] better access to company managements. Scale also leads to lower expense ratios, which of course most directly aid fund returns.

There's plenty of anecdotal evidence for this theory. For example, 20 years ago, American Funds had several of the biggest large-company U.S. stock funds in existence. All of those funds still exist, and all have outgained their benchmarks. Most of Vanguard’s big actively run funds have done well over that same time period, and until its recent problems goliath

As a Matter of Fact Now Fidelity has published a paper that removes the anecdote from U.S. large-company stock funds. As something of a follow-up to American Funds' 2013 claim for active management, which highlighted the performance of low-cost funds at organizations where portfolio managers tended to invest heavily in their own funds, Fidelity has released its own study on the benefits of active management. It argues for owning low-cost funds at very large fund companies.

You have probably noted that both papers sell their companies’ wares. Each firm runs many (relatively) low-cost funds, American Funds’ managers tend to invest heavily in their own funds, and Fidelity is indeed a very large fund company. Well, no shock there; you wouldn’t expect for-profit businesses to publish something that advances somebody else’s cause.

The question is whether the study is fair. I think it is. Fidelity looked at the 23 years from 1992-2014 (the time period was based on data availability), examining the relative performance of three broad stock-fund groups: U.S. large-company funds, U.S. small-company funds, and international large-company funds. In each case, Fidelity used all funds that existed at the time, thus correcting for survivorship bias, and used the oldest available share class if multiple share classes existed. It then compared each one-year return with the return posted by the fund’s official benchmark, as specified in its prospectus.

The results will surprise if you believe the popular press about the awfulness of active management. (Please don’t, it’s not good for your intellectual health.) The average actively run U.S. small-company and foreign large-company stock fund beat their prospectus benchmarks over those 23 years after all ongoing fund expenses. The average margin was about 100 basis points. Active U.S. large-cap funds trailed their prospectus benchmarks but by a moderate 67 basis points, meaning that they did outperform before paying their expenses. To be sure, shareholders can't spend that outperformance--but it does poke a hole into the tale of the dumb fund manager.

- source: Morningstar Analysts

Notching It Up Fidelity then applied its two screens, cost and fund-company size, to the U.S. large-company stock group. (Ostensibly, it skipped the other two groups because they performed well enough without further sifting. However, that Fidelity holds more money in U.S. large-cap stock funds than in the other two groups might also have affected the decision.) The study defined low cost as annual expenses landing in the lowest quartile among the group's actively managed funds and size as being among the five biggest active U.S. large-cap managers. In proper fashion, those screens were determined at the time of each annual measurement, meaning that both the expense cut-offs and lists of largest companies varied over the years.

As shown below, each filter succeeded on its own and worked better yet in combination. The end result was hardly a stunning victory for active management, as the pool of low-cost big-family funds outdid their benchmarks by a modest 18 basis points per year. You may not wish to take on the work of researching and monitoring active funds, plus assume the event risk of owning one, for 18 basis points. On the other hand, as Fidelity points out, the two screens do push the actively managed large-cap group past similarly screened passive funds (that is, cheap and large relative to other U.S. large-cap index funds). And of course, you need not purchase every fund on the list; perhaps additional screens will further improve the odds.

- source: Morningstar Analysts

Which means that based on more than two decades of data, 1) randomly selected active U.S. small-company stock funds, 2) randomly selected active international large-company stock funds, and 3) randomly selected active U.S. large-company funds that were screened for cost and company size outperformed even the best of the index funds. Yes, these figures are not adjusted for risk (not a big issue, as most actively run funds are well diversified and have similar risk profiles to the indexes) or for taxes (a much bigger deal, for taxable accounts), but still ... the active funds won. Those are not words that are often written.

My take: This research, like American Funds' before it, should not dissuade passive investors. There's nothing in there to indicate that indexing is suboptimal. On the other hand, it does indicate that active investors aren't dupes, as commonly portrayed. After all, most of them have been investing in the largest fund companies, and most of them have gravitated toward the cheaper funds. With that approach, they have done pretty well--much better than the popular press has expressed--and they're likely to do so going forward, too.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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