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How Mutual Fund Characteristics Relate to Fund-Capacity Constraints

Morningstar research digs into the factors that can contribute to alpha

Investors in mutual funds have long wondered whether the popularity of a fund—also known as a fund’s capacity—may reduce the potential payout of its strategy. Researchers in this area seek to uncover whether some strategies are more resilient to the accumulation of assets, or whether they have a greater capacity.  

In “ Mutual Fund Capacity: Evaluating Excess Return Through Fund Factors,” our analysts studied historical capacity constraints for mutual funds (as measured by alpha), and identified mutual fund characteristics that are commonly hypothesized to pertain to these constraints.  

These characteristics include:  

  • assets under management,  
  • fund-family assets,  
  • turnover ratio,  
  • number of holdings,  
  • size interquartile range,  
  • style interquartile range,  
  • liquidity, and  
  • crowdedness.  

This study focused solely on the U.S. active equity mutual fund industry to evaluate the relationship between capacity-measurement variants and subsequent performance.   

Below, take a closer look at what we found about several of these factors’ relation to mutual fund capacity. 

What crowdedness reveals about mutual fund capacity constraints

In this paper, we introduce the concept of crowdedness, which measures a fund’s ability to generate alpha by examining the trading space and distance of the fund in relation to other funds. The idea stems from the notion that if many investors hold similar portfolios, the market can become saturated. Excessive saturation can cause funds to reduce their size, to search for different buying opportunities, or to eventually close.  

The image below is a visual representation of this new factor at one point in time, as mapped onto the Morningstar Style Box™. The vertical axis represents fund-size category, while the horizontal axis represents fund-style category. 

Here, we see the large-blend category (the upper portion of the vertical axis) is the most concentrated, and mid- to small-cap categories (the lower portion of the vertical axis) are much more dispersed.  

Our research found that operating in saturated areas of the style box hinder a fund’s ability to earn excess returns. There is a limit on alpha available in any given area of the style box, and even a skilled manager can be restricted by the area of the style box in which they operate. 

The costs associated with mutual fund capacity

Our research also found that managers who increase their trading activity see negative impact. Higher turnover ratios already lead to docked fund returns; but increasing a fund’s level of trading activity can be even more unsustainable, as the costs of this increase outweigh the benefits. High expense ratios can eat into returns, but so do gratuitous trades.   

On the flip side, funds with greater fund-family assets are afforded additional benefits. Larger fund families can absorb the risks and sunk costs of individual funds and access additional resources that aren’t always available at smaller firms. Essentially, larger fund families provide economies of scale and reduce overall costs.      

Breaking down mutual funds into net asset and capacity quintiles

We also explored how a fund’s average annualized forward 12-month alpha varies given its current net asset and capacity quintiles. Assets are divided per Morningstar Category.  

Funds with the most net assets in their category do not necessarily generate the lowest alphas in comparison to their lower-asset peers. However, we can see from the chart below that those with a higher (better) capacity score tend to have a higher average alpha than those with a low-capacity score.  

In the highest-asset quintile (the furthest-left column), in which the most concern regarding asset bloat lies, we see the largest differentiation in alpha.   

A closer look at mutual fund capacity constraints

Our study has allowed us to broaden our understanding of mutual fund capacity constraints and correlate poor investor outcomes with specific capacity characteristics, including high-turnover ratios and excessive crowdedness in a fund space.  

We have been able to isolate an individual factor’s directional effect and measure the magnitude of its impact on an average fund’s excess returns. This has allowed for a clearer understanding of the concept that funds experience decreasing returns to scale. 

To explore the specific findings about each factor, download the full paper.
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