Big funds, small returns
The bigger a fund gets, the less nimble it is.
By Larry Dignan
July 4, 2003
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Anthony Vargo, an investment manager at Legend Financial Advisors in Pittsburgh, has a simple theory when it comes to mutual funds with a lot of assets: Stay away and let an index fund do the work.
And he’s not alone. Financial planners say large mutual funds are more likely to mirror the Standard & Poor’s 500 index mostly because they have little choice but to invest in large liquid companies. A mutual fund with too many assets can’t simply unload positions -— it could take as long as six months to ditch an underperforming stock
“Large funds are more cumbersome,” says Vargo. “It’s clearly difficult for them to liquidate positions.”
And that means mutual funds lugging around more than $15 billion in assets fall short of the S&P 500 more often than not. Fund managers say the S&P 500 benchmark is tough to beat largely because it’s efficient. And because large mutual funds are frequently limited to companies with big market capitalizations, they tend to mimic the index.
“For the most part, asset growth makes it harder to beat the S&P 500 by a lot,” says Russ Kinnel, director of fund research for Morningstar. “By nature most have to be in the megacap stocks and have low turnover.”
The poster child of a large fund that struggles against the S&P 500 is Fidelity’s Magellan, an entity still associated with star money manager Peter Lynch in the minds of the broad public, even though he stopped managing the fund more than a dozen years ago. Through May 23, Magellan had 1-year, 3-year and five-year losses of 13.74 percent, 11.2 percent and 1.28 percent, according to Morningstar. With the exception of the 5-year return, Magellan slightly lags the S&P 500. The differences, however, are so slight one could argue Magellan is basically an index fund.
There’s a reason for that. With $54 billion in assets, second only to the PIMCO Total Return bond fund, Magellan can’t use the fleet-of-foot tactics that Lynch used to bring the fund fame. The difficulty persists even though Magellan has been closed to new investors since Sept. 30, 1997 (the fund still accepts contributions from existing shareholders). “We had to stabilize asset flow and closing it gave us a consistent flow,” Fidelity spokesman Dan Flaherty says. “We manage for total return not size.”
Magellan has kept expenses relatively low for an actively-managed vehicle, but it's not as cheap as a typical fund tracking the S&P 500. Analysts say the big question is whether it’s worth paying extra for something that basically acts like an index fund.
Other large funds trail the S&P 500 by a wider margin. Amer. Century Ultra, for instance, has a one-year loss of 15.24 percent compared to 13.38 percent for the S&P 500. That margin expands slightly for the three-year return before narrowing to about par for the five-year return. Of Morningstar’s tally of mutual funds with more than $15 billion in assets 12 out of 20 equity funds trailed the S&P 500.
Vargo says his approach is to use index funds to target large caps and look to actively managed funds for small-caps. The market for smaller stocks is less efficient and savvy managers can deliver home runs, Vargo believes.
Should there be a target to close funds once they hit a certain asset size? Kinnel says there are times when asset flow becomes too much such as Fidelity’s Magellan. But unless there is a plan in the beginning to close a fund, it usually doesn’t close, according to Morningstar's Kinnel.
“A fund should be closed when it affects style,” he says. “If an aggressive fund is concentrated in a few stocks asset size can enclose it. Janus 20 for
example got too big.”
According to Kinnel, investors should watch asset size, but not automatically rule out funds that are large. After all, there’s a reason funds became big in the first place. For example, Fidelity’s Contrafund and Growth & Income fund each have a bit more than $28 billion in assets, and have outperformed the S&P 500 for the last five years. Both funds were closed to new investors for more than two years before reopening in December 2000.
The key is for funds to adapt their strategies based on their size. Trading costs, economies of scale and portfolio turnover are all things that can hurt return. If a big fund doesn’t use its girth to lower expenses than it’s probably not worth buying.
One strategy that has worked well for Amer. Funds is divvying up a portfolio among several managers. Of Morningstar’s list of large funds, Amer. Funds has seven of them. The smallest having $17 billion in assets. Amer. Funds' Growth Fund of America is outperforming the S&P 500 by a wide margin with others also beating the index.
The Growth Fund of America draws on six portfolio managers, who are experienced in both bull and bear markets. They each get a corner of the
portfolio and pick growth stocks, turnaround and cyclical companies. The fund, which charges a sales commission of 5.75 percent, still has to hold big blocks of shares due to its size, but has hit a few home runs with purchases of Comcast, USA Interactive and Liberty Media. According to Morningstar, the fund has also managed to keep expenses low and gets a five-star rating.
While Amer. Funds may have been able to outrun its size, the law of averages dictates that large-cap funds can’t beat the S&P 500 index by much. Factoring fees and other costs and indexing may be the way to go.
Harold Evensky, principal of Evensky, Brown & Katz, a Coral Gables, Fla. Financial planning firm, is a big believer in indexing. He advocates building a
diversified portfolio with index mutual funds and exchange traded funds like the QQQ, which mimics the Nasdaq 100. If an investor is dollar-cost-averaging index mutual funds make more sense, but if there’s a lump sum, an exchange-trade fund makes more sense, Evensky says.
Would he change his mind if more mutual funds watched their asset size and closed? “The decision to close a fund depends on what side you’re on,” says Evensky. “If I’m an investor I would want it closed. If I’m Fidelity I don’t think I’d want to because I’d be making too much money.”
For Evensky, however, it’s all academic.” Large caps are extremely efficient,” says Evensky. “I don’t think most large cap funds can beat the system.”
| Largest actively-managed funds |
| Fund | Assets | 5-year annual return |
| PIMCO Total Return Instl | $75.8 billion | 8.3% |
| Fidelity Magellan | $58.7 billion | -0.85% |
| Amer. Funds Invmt Co of Amer | $54.2 billion | 3.27% |
| Amer. Funds Washington Mutual | $51.4 billion | 2.18% |
| Amer. Funds Growth Fund of Amer | $46.2 billion | 7.15% |
| Fidelity Contrafund | $29.6 billion | 2.64% |
| Amer. Funds Income Fund of Amer | $28.4 billion | 4.8% |
| Fidelity Growth & Income | $27.7 billion | -0.72% |
| Amer. Funds EuroPacific Growth | $26.5 billion | 1.68% |
| Amer. Funds New Perspective | $25.1 billion | 3.86% |
| Amer. Century Ultra Inv | $20.7 billion | -1.79% |
| Amer. Funds Amer. Balanced | $20.2 billion | 7% |
| Putnam Fund for Growth & Income | $20 billion | -0.63% |
| Fidelity Puritan | $19.2 billion | 2.93% |
| Fidelity Blue Chip Growth | $18.9 billion | -2.59% |
| Fidelity Equity-Income | $18.3 billion | 0.55% |
| Davis NY Venture | $18 billion | 2.18% |
| Amer. Funds Fundamental Invs | $17.4 billion | 2.02% |
| Amer. Funds Capital Inc Bldr | $17 billion | 5.29% |
| Janus | $16.7 billion | -2.94% |
| Amer. Funds Bond Fund of Amer | $16.5 billion | 6.29% |
| AXP New Dimensions | $16.3 billion | -0.41% |
| Fidelity Growth Company | $16.1 billion | 2.21% |
| Fidelity Low-Priced Stock | $15.7 billion | 9.74% |
| Franklin CA Tax-Free Income | $14.6 billion | 5.34% |
| Fidelity Dividend Growth | $14.2 billion | 3.23% |
| Dodge & Cox Stock | $14 billion | 8.13% |
| PIMCO Low Duration Instl | $12.9 billion | 6.62% |
| Lord Abbett Affiliated | $12.4 billion | 3.23% |
| Source: Morningstar. Data as of June 27, 2003. |
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