For Mutual Funds, Smaller Isn't Always Better

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.