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Portfolio > Mutual Funds

For Mutual Funds, Smaller Isn't Always Better

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Index May 2004 QTD YTD Description
S&P 500 Index* 1.21% -0.49% 0.79% Large-cap stocks
DJIA* -0.36% -1.64% -2.54% Large-cap stocks
Nasdaq Comp.* 3.47% -0.37% -0.83% Large-cap tech stocks
Russell 1000 Growth 1.86% 0.68% 1.47% Large-cap growth stocks
Russell 1000 Value 1.02% -1.44% 1.54% Large-cap value stocks
Russell 2000 Growth 1.99% -3.13% 2.28% Small-cap growth stocks
Russell 2000 Value 1.21% -4.02% 2.61% Small-cap value stocks
MSCI EAFE 0.43% -1.75% 2.57% Europe, Australasia & Far East Index
Lehman Aggregate -0.40% -2.99% -0.41% U.S. Government Bonds
Lehman High Yield -0.68% -2.36% -0.07% High-yield corporate bonds
Calyon Financial Barclay Index** -1.38% -4.89% -1.34% Managed futures
3-month Treasury Bill 0.33%
All returns are estimates as of May 31, 2004. *Return numbers do not include dividends. **Formerly the Carr CTA Index.

Common wisdom dictates that as mutual funds get larger, returns get worse. As a fund’s assets increase, it becomes increasingly difficult to trade in all but the largest stocks, which can restrict the opportunity set for fund managers to only the most liquid (and the most efficiently-priced) stocks. But the biggest culprit is often market impact, which is the difference between the market price and the execution price of a stock. Market impact can be significant, and is often sufficiently large to render promising trades economically infeasible. Perhaps Vanguard’s John Bogle said it best. Speaking before the Society of American Business Editors and Writers in Denver last fall, he noted that “Growth in a fund’s assets to elephantine size enriches managers but destroys the fund’s ability to repeat the performance success that engendered that very growth. The bigger the fund, the bigger the fee, and the more likely the fund’s reversion to the market mean.”

Although the ‘smaller is better’ mindset gets a lot of traction among investors, there are still a few scenarios when capping money under management can be problematic. Suppose, for example, that a successful actively managed fund decides to close its doors to new investment, from both new and existing clients, because its managers feel that asset size has become an impediment to good performance. That noble sentiment could well lead to better returns–unless the fund’s underlying index starts sinking.

It’s hardly fair to criticize any small-cap manager for the return of his or her underlying index, but inevitably, if a given asset class starts sinking, there will always be investors who will jump ship. It’s their right to do so, of course, and typically fund managers can at least partially replace redemptions with additions. That’s true unless they have decided to close their fund to new additions. A closed fund can face a genuine liquidity problem if the only door available to investors is an exit. This can be especially true for relatively illiquid sectors such as high-yield bonds, small-cap stocks, and emerging markets.

What should an investor do when faced with an impending “hard” close? First, the most common time a fund will stop taking new clients is after a fairly good run-up in the underlying market. As a student of investor psychology, that is a better signal that things may start heading in the other direction, i.e., down, than a sign that better times are ahead. An investor may consider redeeming before a fund closure, with the thought that selling his appreciated shares to the guy behind him isn’t the worst thing that could happen.

A less dramatic solution may be to simply rebalance to an investor’s target allocations. If an asset class has gone up so much that mutual funds focusing on that class are not accepting new money, there’s bound to be a significant deviation from one’s target allocation percentages.

Please note that this advice doesn’t apply to investment vehicles that depend more on manager skill, or alpha, like hedge funds. The best hedge funds are closed, and aren’t likely to ever re-open, so if you get in a good one you should consider yourself fortunate.