I need help figuring out if my large fund is having trouble maneuvering its weight around.
QUESTION: I own a diversified portfolio of mutual funds. Within my portfolio, I hold one microcap fund and one focused fund. Both have more than a billion dollars in total assets, and I am concerned that they may not have the same investing flexibility they once had. How big is too big?
ANSWER: When it comes to mutual funds, size does matter. In some ways having substantial assets can be, well, an asset. But there?s a downside, too.
Among the pluses, large funds, particularly large-cap index funds, tend to be tax-efficient, meaning less pain for you come tax time. Because a big, popular fund receives a steady stream of new investments, the fund manager is rarely forced to sell holdings just to meet redemptions, which can trigger capital gains, explains Morningstar senior analyst Peter Di Teresa. In addition, you may pocket extra gains if your large fund shares its economies of scale with investors by reducing annual expenses. A Securities and Exchange Commission study released in January shows that as funds grow, their expense ratios fall. For example, funds with more than $1 billion in assets charge weighted expense ratios of 0.87% on average, whereas portfolios ranging in size from $201 million to $1 billion charge 1.14%. Finally, a big fund is far less likely to fold than a fund whose assets total only tens of millions, says Di Teresa.
As you suspect, the chief disadvantage of size is that a fund may become less nimble. There?s no hard rule for when that starts to be an issue, but size does become a challenge for different types of funds at different points, and smaller-cap funds are particularly sensitive. "Especially in small-cap and microcap funds, if you have to spread your good ideas around to too many kinds of stocks, your performance is going to suffer," explains certified planner Ross Levin of Edina, Minn.-based Accredited Investors, who sets a limit of $500 million on such portfolios. So your $1 billion microcap portfolio is too big for his liking. Similarly, Levin steers clear of midcap funds with more than $2 billion. Some managers of oversized funds goose returns by placing large — and therefore risky — sector bets, rather than relying on individual stock selection, Levin says. So ultimately, he warns, size "becomes a burden." The pitfalls of bulk probably don?t apply to your focused fund at its current size, though. Focused funds typically invest in fewer than 40 stocks, and aren?t necessarily small-cap or midcap funds. "There are some focused funds with tens of billions in assets," notes Di Teresa. "So it?s doable." Large-cap funds and especially large-cap index funds are even better equipped to deal with substantial assets, although they too can get bogged down by their bulk, Levin says, pointing to the roughly $100 billion Fidelity Magellan fund (FMAGX), which he says makes big sector bets and whose performance has slackened along with its tremendous asset growth.
If you?re concerned that your fund has grown unwieldy, hold it up to its smaller, friskier, competitors. "What you want to focus on is your fund's performance relative to its peers," Di Teresa says. Even if your fund?s relative returns look healthy, you aren't out of the woods until you?ve also compared the risk each fund has taken on. To see if a fund has been taking chances to keep pace with the pack, scan our site's fund snapshots, which rely on Morningstar?s risk data.
Should you decide one or both of your funds have outgrown their usefulness, your best option may still be to stay put. If the fund's in a taxable account, moving out of it could trigger a tax bill that could take years to recoup. If you?d rather avoid a tax hit, you could keep that account and put any new investments earmarked for microcap investing into a smaller portfolio. Finally, says Levin, stay on guard against style drift. When faced with large assets to invest, small-cap fund managers, for example, can either increase the number of holdings, or turn to larger-cap stocks to fill the bill — in which case the fund starts losing its small-cap focus.
The bottom line: If a little research confirms that your fund has begun to waddle, and you won't suffer from too much of a tax sting, you might well want to consider a leaner alternative. Sometimes, the giant economy size isn't such a deal after all.