Bigger is usually better. But a super sized fund can be troublesome. As hot shot funds grow, their returns often become sluggish, weighed down by too many assets. They lose their potency and become average.
Asset size can impede performance for any fund, but some types of funds are hurt more than others. It depends on a fund's style. Note that bond funds don't typically struggle with asset growth. Individual corporate bonds may have less of an impact on performance as bond fund's assets grow, but in general the bond market is sufficiently large that asset growth doesn't hamper many bond fund managers.
Asset size and market cap
A fund's asset size is simply the total amount of pounds invested in the
fund at a certain point in time--it is the fund's net asset value
multiplied by the number of shares outstanding. Most funds report their
assets monthly; the net asset figures on Morningstar's Fund Reports are
usually as of the most recent month end.
There's no direct relationship between a fund's size and the size of the companies in which it invests. A fund with a £10 billion asset base, for example, doesn't necessarily own large-cap companies with £10 billion market capitalisations. It can buy stocks of any size—theoretically, at least.
We say "theoretically" because very large funds may have difficulty buying very small stocks. It's tough to put large pound amounts to work in a small market. In terms of number, large-cap stocks are a small part of the market but in terms of market cap, they dominate. It's therefore easier for a fund manager with a lot of assets to buy bigger companies than to own small fry.
Let's say, for example, that Fund X, with almost £20 billion in assets, is really bullish on Small-Cap Y, the value of whose shares totals about £500 million. Fund X wants to make it a large part of its portfolio, but it can't as even is it were to buy all of Small-Cap Y--and legally it couldn't--Small-Cap Y would still only make up 2.5% of its portfolio. A fund with fewer assets would have a much easier time loading up on these shares.
Asset size and turnover
It would seem that too many assets pose the biggest threat to
small-company funds. But Morningstar's preliminary research, which
examined the risk-adjusted performance of all types of funds, suggests
that isn't necessarily the case. We've found that asset size is not a
problem for all small-company funds. Instead, asset overload tends to
threaten growth funds of all market capitalisations and is especially
detrimental to small-cap growth funds that trade a lot.
In fact, trading seems to be the key. Value funds trade far less than growth funds and therefore incur lower trading costs. (The average growth fund's turnover rate is well over 100%, much higher than the average value fund's.)
When most people think of trading costs, they think only of brokerage commissions—less trading, lower costs. But there is a second component of trading costs: the cost of "moving the market." This is a component that is directly affected by asset size. Funds can "move" the market when they are unable to buy stocks without pushing the share price of that company upward as they're buying; likewise, funds that are "market movers" cannot sell stocks without pushing the price downward as they're selling.
Think of the stock market as a giant auction house. In an auction, the price of an object goes up as more people bid for it. As more people enter the bidding, the price rises, making the object more expensive for the eventual purchaser. Now think of each pound in a fund as another bidder. The larger the fund, the more likely it will be to boost a firm's share price simply by "bidding" on its shares.
Growth and value funds are both affected by this phenomenon, but growth funds usually suffer more. That's because growth managers are usually competing with plenty of other buyers for popular merchandise—high-priced, high-growth stocks. Value managers, on the other hand, experience a lot less competition and, thus, prices don't get "moved" nearly as much.
How funds can manage asset growth
There are a few things funds can do to manage asset growth. First, they
can close. Closed funds don't accept money from new investors, but
they'll usually continue to take investments from current shareholders.
Their asset bases may grow, but at a more moderate pace than when they
were open. Some funds close to current investors, too, which means that
even those who own the fund already can't contribute any more to it. But
that's pretty rare.
More often than not, fund managers cope with huge asset bases by altering their strategies. Some will buy more stocks, others will start buying larger stocks, and still others will hold cash because they can't find enough stocks to buy.
How you can handle asset growth
So what does all this mean for your portfolio? Well, you probably don't
have to worry as much about your value funds getting too big. But keep
an eye out for sluggish risk-adjusted performance from your fast-trading
growth funds as their asset bases rise.
When choosing growth funds, you can tilt the odds in your favour a few ways. Favour funds and fund shops that vow to close at a particular asset size. Adventurous types often try jumping into hot growth funds and then jumping out once they gather too many assets. Be warned: that practice could just as easily lead to large losses as to great returns, and because of the selling that you'll inevitably have to do, it's not suitable for taxable accounts.
As assets grow, keep an eye out for strategy changes. If you bought a fund to fit a small-growth niche in your portfolio, you might not be happy if its median market cap creeps up. A fund with a big cash stake can throw off your own asset-allocation decisions. Even if a growing fund is thriving, asset growth may still mean problems.
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