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Morningstar.com's Interactive Classroom

Course 503
Where and Why Asset Size Matters

Introduction

Bigger is often better. Most people would prefer a rambling villa to a studio apartment. And everyone remembers the popularity of the Super Size meal at McDonald's (MCD).

But as it turns out, the Super Size meal was a disaster for American health; McDonald's discontinued it in 2004. And super sized mutual funds can be just as troublesome. As hot shot funds grow, their returns may become sluggish, weighed down by too many assets. They lose their potency and become average. It happened to Fidelity Magellan (FMAGX), which is no longer the total-return powerhouse it was when it had less than a billion dollars under its belt.

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 a 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 dollars invested in the fund at a certain point in time; it is the fund's NAV 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 capitalizations. 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 dollar amounts to work in a small market. Small-cap stocks take up less than 10% of the U.S. market's overall assets; large caps, meanwhile, account for about two thirds of the market. In other words, in terms of number, large-cap stocks are a small part of the market (as you know, there just aren't an unlimited number of GE-size firms). In terms of market cap, though, they dominate. It's therefore easier for a fund manager with a lot of assets to buy bigger companies than to own a small fry.

Let's take an example. If Fidelity Contrafund, with $81 billion in assets in mid 2011, was really bullish on resort owner Gaylord Entertainment (GET) and wanted to make it a large part of its portfolio, it couldn't. The value of all of Gaylord Entertainment's shares combined is about $1.6 billion; if Contrafund could buy all of it-and legally it cannot-Gaylord would still make up just over 1% of the 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 asset size is not a problem for all small-company funds. Instead, asset overload is especially detrimental to small-cap funds that trade a lot.

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 dollar in a mutual 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. And the more frequently a larger fund trades, the more likely it is to rack up high trading costs, often called "market impact costs."

Growth and value funds are both affected by this phenomenon, but fast-trading 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. They're like the people who go to auctions and bid on Jackie Onassis' jewelry. Value managers, on the other hand, are like shoppers combing through yard sales every weekend. Because there's a lot less competition for a beaten-up lawn chair with hidden potential than for Jackie's string of pearls, 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. Heartland Value (HRTVX), for example, held about 50 stocks when it had just a few hundred million dollars in assets; when assets topped $2 billion in 1997, the fund owned more than 300 names. (As assets dropped back down, the fund's portfolio has gotten more trim, but it still holds more than 140 names.) Other funds will start buying larger stocks, as American Century Ultra (TWCUX) did. Still others will hold cash, because they just 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.

And if you want to be proactive, 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 it starts buying midsize or even large-cap stocks. 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.

Quiz 503
There is only one correct answer to each question.

1 Why can very large funds have difficulty buying very small stocks?
a. Because it's tough to put large dollar amounts to work in a small stock without affecting its share price in the process.
b. Because the small-cap market is so big.
c. Because small-cap stocks are tough to research.
2 Which type of fund tends to be the most threatened by asset growth?
a. Large-cap funds.
b. Low-turnover growth funds.
c. High-turnover small-growth funds.
3 What is not something funds typically do to handle asset growth?
a. Close to new investors.
b. Alter their strategies.
c. Own fewer stocks.
4 If you're concerned about asset growth, what should you do?
a. Favor funds with low turnovers rates.
b. Buy aggressive, fast-trading funds.
c. Don't buy any funds that focus on smaller-cap stocks.
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